When planning for retirement, most people concentrate on how much to save and how to invest for growth. Both are critical, but they only tell part of the story. The true measure of retirement success isn’t the size of your account; it’s how much you can actually spend each year without running out of money.
That’s where taxes come in. Two retirees with the same $1 million nest egg can end up with very different lifestyles depending on how their assets are structured. The difference isn’t investment returns; it’s the tax rules that apply when money comes out.
This is why tax planning belongs at the heart of retirement income planning. Saving diligently and investing wisely is only half the battle; the other half is arranging your accounts so that the tax impact on your withdrawals is as small as possible. That’s where asset location, or deciding which investments are placed in each account type, comes in. Done well, asset location can stretch your retirement dollars further by minimizing the taxes paid on your income.
Understanding the Three Main Account Types
Not all accounts are created equal. When you save for retirement, your money can end up in three broad “buckets,” and each one has its own set of tax rules. Think of it like storing food: some goes in the pantry, some in the refrigerator, and some in the freezer. They all preserve your food, but in different ways. Similarly, taxable, tax-deferred, and tax-free accounts each preserve your money in different ways.
Taxable Accounts
These are brokerage accounts funded with after-tax dollars. Each year, you may owe taxes on interest, dividends, or realized capital gains when you sell holdings. Certain types of qualified dividends and long-term capital gains are often taxed at lower rates than ordinary income. These accounts also allow for flexible withdrawal strategies, since you can often control the timing of taxable gains and use harvested losses to offset other income. Taxable accounts generally receive a step-up in basis at death, reducing heirs’ capital-gains taxes if they sell.
Tax-Deferred Accounts
Traditional 401(k)s and IRAs are examples of tax-deferred accounts. They are funded with pre-tax dollars, meaning that investments grow tax-deferred until you take distributions. But when you withdraw, every dollar is taxed as ordinary income. Starting at age 73 (for most current retirees, but it could be later depending on your age), the IRS requires you to take required minimum distributions (RMDs), whether you need the money or not. Holding too much in tax-deferred accounts can create an RMD surprise that pushes you into higher tax brackets or increases Medicare premiums, making diversification across account types a worthwhile consideration.
Tax-Free Accounts
Roth IRAs and Roth 401(k)s are examples of tax-free accounts. They are funded with after-tax dollars, and since assets in the account have already been taxed, qualified withdrawals in retirement are tax-free. Because withdrawals are tax-free, Roths are often the best home for higher-expected-return assets, allowing the greatest growth to avoid taxation. Unlike traditional accounts, Roth IRAs also avoid RMDs during your lifetime, giving you more flexibility.
Applying Asset Location Principles
Once you’ve decided on your overall asset allocation (the mix of stocks, bonds, and other investments that fits your risk tolerance and goals), the next step is figuring out where to place those assets. This step is known as asset location, and while it doesn’t change what you own, it can change how much of your returns you get to keep. By holding your investments in an account that offers favorable tax treatment, you can reduce the drag of taxes and potentially increase your after-tax income in retirement.
- Taxable accounts are best suited for tax-efficient investments like index funds, municipal bonds, or ETFs that generate little taxable income. These accounts can take advantage of favorable long-term capital gains rates, tax-loss harvesting opportunities, and the step-up in basis at death.
- Tax-deferred accounts are a good fit for tax-inefficient assets like high-yield bonds, REITs, or actively managed funds that generate a lot of taxable income. The tax-deferred wrapper on the account shields you from paying taxes each year, though withdrawals will eventually be taxed as ordinary income.
- Roth accounts are ideal for growth-oriented investments such as small-cap or emerging market stocks. Since qualified withdrawals are tax-free, all the future appreciation from those investments avoids taxation altogether.
When it comes time to take withdrawals, it’s important to coordinate them with Social Security and Medicare to avoid unexpected tax consequences, such as the Social Security ‘tax torpedo’ (where benefits become taxable) or IRMAA surcharges (which raise Medicare premiums). There’s no single formula that works for everyone. The best approach depends on your mix of available account types, income needs, tax bracket, and long-term goals. Because these rules are complex and highly individualized, it’s wise to consult a tax professional before implementing a strategy.
If you’re looking to put these principles into action, our Creating Tax Efficiency for Retirement Income Workshop inside the Retirement Researcher Academy is a great place to start. It walks through how to coordinate account types, withdrawals, and tax brackets to help your retirement income go further. Academy members also get access to advanced tools like our Using Tax Maps Workshop, which shows how future tax planning decisions ripple through time. Whether you’re just getting started or ready to go deeper, the Academy provides the education and tools to make more confident, tax-smart decisions.
By making tax planning a central part of retirement income strategy, you can reduce tax drag, boost after-tax income, and make your savings last longer in retirement.
Want to learn more? Listen to Ep. 197 of the Retire With Style Podcast.
