Here's something I see with a lot of the people I work with.
Two couples can have the same amount saved, invest it the same way, earn the same returns, and still end up with very different amounts to spend in retirement.
A big part of the difference is where the money sits. How much is in traditional IRAs and 401(k)s, how much is in Roth accounts, and how much is in a regular taxable brokerage account.
Each of those is taxed differently. And once you start living off them, those differences don't just show up in your tax bill. They show up in your Medicare premiums, in how much of your Social Security gets taxed, and in what your spouse and your kids eventually inherit.
In this article, I'll go through each type of account, how it's taxed, and then how they affect each other once you're drawing income in retirement.
Traditional IRAs and 401(k)s: Taxed as Ordinary Income
Let's start with the account type most people have the most money in.
With a traditional IRA or 401(k), you put money in before tax. It grows without being taxed along the way. And when you take it out in retirement, every dollar is taxed as ordinary income, the same as a paycheck.
The deduction is a deferral, not a discount
The way I'd think about that upfront deduction is that you're postponing the tax, not avoiding it.
Say you're in the 24% bracket and you put $20,000 into your 401(k). You save about $4,800 in tax that year. But you haven't gotten out of that tax. You've pushed it into the future, and it will be taxed at whatever rate you're in when the money comes out.
That can work in your favor. If you were in the 24% bracket while you were working and you're in the 12% bracket in retirement, deferring was a good trade. That's the whole case for these accounts.
The problem is when it doesn't work out that way. And with larger balances, it often doesn't.
Required minimum distributions (RMDs)
The reason is required minimum distributions, or RMDs. At a certain age, the IRS makes you start taking money out of your pre-tax accounts, whether you need it or not. Under current law, that starts at 73, or 75 if you were born in 1960 or later.
The required amount is a percentage of your balance, and that percentage goes up every year as you get older.
To put a number on it, if you're 85 and have $1.5 million in an IRA, your required withdrawal that year is a little over $90,000. Put Social Security and any other income on top of that, and someone who expected to be in a low bracket in retirement can end up right back where they were while they were working.
If almost everything you saved is in traditional pre-tax accounts, you don't have much control over that. By the time RMDs start, a lot of your options are gone.
Roth IRAs and Roth 401(k)s: Tax-Free Withdrawals
Roth accounts work the other way around.
You put in money you've already paid tax on. There's no deduction. But qualified withdrawals in retirement are tax-free. Qualified generally means you're over 59½ and the Roth has been open at least five years.
And tax-free here means it really doesn't show up anywhere. A qualified Roth withdrawal:
• Doesn't push you into a higher tax bracket
• Doesn't count toward your Medicare premiums
• Doesn't affect how much of your Social Security is taxed
The growth is tax-free too. If an investment doubles inside a Roth, you never pay tax on that gain. If it doubles inside a traditional IRA, you'll eventually pay ordinary income tax on all of it.
There are also no required distributions from Roth accounts during your lifetime. If you don't need the money, it can stay there and keep growing.
A Roth isn't automatically the better choice
With a Roth, you're paying the tax up front, at today's rate. If your rate later on would have been lower, you paid more than you needed to.
Which one comes out ahead mostly comes down to your tax rate now versus your tax rate later.
Taxable Brokerage Accounts: Capital Gains and a Step-Up in Basis
The third type is a regular taxable brokerage account. People tend to overlook it in retirement planning, but it has some real advantages.
Lower tax rates on long-term gains
When you sell an investment you've held for more than a year, the gain is taxed at long-term capital gains rates, not ordinary income rates. For a lot of retirees that's 15%, and for some it's zero.
And you're only taxed on the gain, not on the whole amount you take out. Compare that to a traditional IRA, where every dollar that comes out is ordinary income.
A step-up in basis for your heirs
The second advantage is for your heirs. It's called a step-up in basis.
Say you bought a stock for $50,000, and it's worth $200,000 when you die. Your heirs inherit it at $200,000. That $150,000 gain is generally never taxed.
Traditional IRAs don't get that. When your kids inherit a traditional IRA, the money is still taxed as ordinary income when it comes out.
That difference can affect which accounts you spend first and which ones you might leave alone.
How Your Withdrawals Affect Social Security, Medicare, and Your Family
Here's where it gets more interesting. These accounts don't just affect your income tax. They interact with other parts of retirement.
Social Security taxes and the "tax torpedo"
Up to 85% of your Social Security benefit can be taxable. How much depends on your other income.
So in certain income ranges, taking an extra dollar out of your IRA does two things. That dollar is taxed, and it also makes more of your Social Security taxable. One extra dollar from the IRA can add up to about $1.85 of taxable income. Planners call this the "tax torpedo."
Roth withdrawals don't count in that calculation.
Medicare premiums and IRMAA
Your Medicare Part B and Part D premiums go up once your income passes certain levels. That surcharge is called IRMAA, the Income-Related Monthly Adjustment Amount.
What catches people off guard is the timing. Medicare looks at your income from two years earlier. So a large IRA withdrawal this year can raise your premiums two years from now. At higher income levels, that can be thousands of dollars a year, per person.
Again, Roth withdrawals aren't counted.
The widow's penalty
Here's a situation I see a lot.
A married couple has their income set up well. They're in a reasonable bracket, and everything fits. Then one of them passes away.
Starting the year after, the surviving spouse generally files as a single taxpayer. For most income levels, the single brackets are about half as wide as the married brackets. The Medicare surcharge thresholds are lower too.
But the income usually doesn't drop nearly as much. The survivor keeps the larger of the two Social Security checks and loses the smaller one. They inherit the IRA, so the required distributions keep coming.
So you end up with similar income, taxed as one person instead of two. That's often called the widow's penalty.
It's one of the main reasons I look at Roth conversions while both spouses are still alive. You're paying the tax at married rates, instead of leaving it for the survivor to pay at single rates.
When your kids inherit
One more piece is what happens when your kids inherit.
Under current rules, most non-spouse beneficiaries have to empty an inherited IRA within ten years. And if you'd already started your required distributions, they generally have to take some out every year along the way, too.
With a traditional IRA, all of that is ordinary income, and it often lands in your kids' highest-earning years. A $500,000 IRA spread over ten years could add $50,000 or more a year to their taxable income.
An inherited Roth has the same ten-year rule. But the withdrawals are tax-free, and there are no annual distributions. They can leave it to grow for the full ten years if they want to.
For kids who are already in a high bracket, that difference can be large.
What This Means for Your Retirement Withdrawals
So what do you actually do with all this?
Most people I work with have money in all three: traditional, Roth, and taxable. The order you draw from them, and how much you take from each one in a given year, makes a big difference over a whole retirement.
There's no single right order. It depends on your income, your bracket, when you take Social Security, how big your RMDs will be, and what you want to leave behind.
Roth conversions
One tool that comes up a lot is the Roth conversion. You move money from a traditional IRA into a Roth, and you pay tax on it now.
Done in a low-income year, a conversion can mean smaller RMDs later, more money you can draw tax-free, and a smaller tax problem for a surviving spouse or for your kids.
But it has a cost. The amount you convert counts as income that year, and you pay the tax now. It can raise your Medicare premiums two years later. If you're already on Social Security, it can make more of that taxable. And if you're under 65 and buying your own health insurance, it can reduce your premium subsidies.
So with a conversion, the real question is whether the tax you'd pay now is less than what you'd likely pay later, either you or your heirs.
For a lot of people, the best years to look at this are after they stop working and before Social Security and RMDs start. That's often when income is lowest.
And you have to judge it over your whole retirement, not one year. Paying more tax this year can make sense if it means paying a lot less over the next twenty.
Pulling It Together
Traditional pre-tax accounts give you a deduction now, but every dollar is taxed later, and RMDs eventually force the money out.
Roth accounts cost you tax up front, but the money comes out tax-free and doesn't affect your Medicare premiums or how your Social Security is taxed.
Taxable accounts get capital gains rates, and your heirs get a step-up in basis.
And the way these accounts interact with Social Security, Medicare, a surviving spouse, and your kids matters as much as how each one works on its own.
If you haven't looked at this in a while, a good place to start is just writing down how much you have in each type of account. Then ask yourself whether you have a plan for which accounts you draw from and when, or whether you're just taking it from wherever is easiest.