How to Plan Ahead for Taxes in Retirement

February 14, 2023
Selecting tax-smart accounts may help your retirement savings last longer.

Diversification isn't just for your investment portfolio. If you're actively saving for retirement, it's also a good idea to diversify how and when your savings will be taxed. Doing so can help you successfully navigate two unknowns in retirement:

  1. How much of your income will be taxable? You need to consider not just your retirement savings but also Social Security, pensions, nonretirement investments, and other potential sources of income.
  2. What will your tax rate be after you retire? Today's rates are relatively low by historical standards, and it's conceivable they could rise before or during your golden years.

Given these unknowns, it's still possible to plan for a potentially better tax outcome. "One approach is to use accounts with a variety of tax treatments so you can better control your taxable income in retirement," says Rob Williams, managing director of financial planning, retirement income, and wealth management at the Schwab Center for Financial Research.

The big four

Broadly speaking, you have four account types at your disposal, each with its own unique tax advantages:

1. Tax-deferred accounts

Contributions to these accounts—which include 401(k)s, 403(b)s, and traditional IRAs—generally reduce your taxable income dollar for dollar in the year you make the contribution. What's more, pretax contributions and gains aren't usually taxed until retirement,1 at which point withdrawals are subject to ordinary income tax rates.

You can't leave your savings in these accounts forever, though: The IRS requires you to take required minimum distributions (RMDs) from your tax-deferred savings accounts each year starting at age 73 unless you're still working and contributing to your current employer's plan.2

2. Roth accounts

Unlike tax-deferred accounts, contributions to Roth 401(k)s and Roth IRAs are made with after-tax dollars, so they won't reduce your current taxable income. But when you withdraw the money in retirement, you won't owe taxes on appreciation, income, or withdrawals.3

A Roth IRA is exempt from RMDs (unless you inherit it). Currently, a Roth 401(k) is not—although if you retire in 2023, you can still avoid RMDs by rolling it into a Roth IRA. SECURE Act 2.0 does away with Roth 401(k) RMDs starting in 2024.

3. Taxable accounts

These traditional bank and brokerage accounts are also funded with after-tax dollars. For brokerage accounts, you can sell securities and contribute or withdraw money at any time and for any reason without penalty. Any taxable investment income is taxed in the year it's earned, and investments sold for a profit are subject to capital gains taxes. If you sell an investment for a loss, you may be able to use it to offset any gains—and/or up to $3,000 of ordinary income. These accounts are also exempt from RMDs.

4. Health savings accounts

Although not traditionally considered retirement accounts, health savings accounts (HSAs) can be an effective savings vehicle (if your employer offers one, and you're covered by an eligible high-deductible health plan). Contributions reduce your taxable income up to annual limits, investments grow tax-free, and you pay no tax on withdrawals for qualified medical expenses. Once you reach age 65, withdrawals for nonmedical purposes will be taxed as ordinary income.4 HSAs are also exempt from RMDs.

Tax diversification in action

So, what's the right mix of retirement accounts for you? "That depends on several factors, including your current marginal tax rate, your tax rate in retirement, and how much flexibility you'd like when making withdrawals in retirement," says Hayden Adams, CPA, CFP®, and director of tax and wealth management planning at the Schwab Center for Financial Research. Nevertheless, there are some basic guidelines you can consider when deciding which retirement accounts to fund first:

Capture your match

If your employer offers matching contributions to your retirement account, your first priority should be to save enough to get the full match. "That's free money, and you'd be ill-advised to leave it on the table," Rob says.

Consider an HSA

"We're all likely to have increased medical expenses in retirement," Hayden notes. "So, why not pay for them with tax-free dollars?" In 2023, individuals can contribute up to $3,850, families can contribute up to $7,750, and account holders age 55 or older can contribute an additional $1,000. Employers sometimes provide matching contributions, though they'll count against the annual limits.

Maximize your tax-advantaged savings

Next, consider an appropriate combination of tax-deferred and Roth accounts, depending in large part on your current tax bracket:

  • If you're in a lower tax bracket (0%, 10%, or 12%), consider maxing out your Roth accounts. "There's a chance your tax bracket in retirement will be equal to or higher than it is today, particularly when you consider that tax rates are at the lowest levels we've seen in decades," Rob says. "Workers early in their careers, in particular, may be in a lower tax bracket than they will be later in life."
  • If you're in a middle tax bracket (22% or 24%), consider splitting your retirement savings between tax-deferred and Roth accounts. "It can be especially difficult for people in the middle tax brackets to predict their future tax rates, but if you contribute to both types of tax-advantaged accounts you may alleviate some of that uncertainty," Hayden stresses. If the majority of your workplace savings are in a traditional 401(k), for example, you might opt to diversify with a Roth 401(k), if your employer offers one.
  • If you're in a higher tax bracket (32%, 35%, or 37%), there's a good possibility your tax rate in retirement will be the same as or lower than it is today, so maximizing your tax-deferred accounts might make the most sense.

Invest tax-efficiently in a brokerage account

If you still have more left to save after you've taken the steps above, consider investing in a traditional brokerage account. Income generated in these accounts is generally taxable, but there are strategies you can employ to improve their tax efficiency, such as:

  • Holding appreciated investments for more than a year so you can take advantage of long-term capital gains rates, which range from 0% to 20%, depending on your income.
  • Limiting investment trades to avoid unnecessary taxes on your returns. Depending on your tax bracket and how much you trade, each trade can potentially create a "tax drag" that can reduce your after-tax returns by 1% to 3% annually.5 Compounded over 30 years, overtrading could result in a lot of returns lost to taxes.
  • Considering tax-efficient investments—such as exchange-traded funds, index mutual funds, and tax-managed funds—which by and large don't create as many taxable distributions as actively managed funds.
  • Opting for tax-advantaged municipal bonds, especially if you're in a high tax bracket. The interest paid on such bonds is typically free from federal taxes and, if issued in your home state, is generally free from state and local taxes as well.

Consider a Roth conversion

If your income precludes you from contributing to a Roth IRA,6 one potential option is a Roth conversion. With this strategy, you convert all or a portion of funds from a traditional IRA to a Roth IRA and pay ordinary income taxes on the converted amount in the year of the conversion. "Despite the additional taxes, a Roth conversion can help diversify a mostly tax-deferred portfolio," Rob explains. 

However, "the conversion amount is considered income, which could nudge you into a higher bracket if you're not careful," Hayden warns. "That's why many people opt to perform several Roth conversions over multiple tax years." If you're unsure how much to convert in a given year, a tax professional can help you decide.

"Anticipating future tax rates is always a bit of a guessing game," Rob says. "But with a number of account types at your disposal, there's potential to build in flexibility and a surprising level of control over future tax bills."

1Tax-deferred withdrawals are subject to ordinary income tax and may be subject to a 10% federal tax penalty, if taken prior to age 59½. Withdrawals for birth and/or adoption expenses can be made up to a certain limit without a penalty.

2If you continue to work past age 73, and do not own more than 5% of the business you work for, most plans allow you to postpone RMDs from your current—but not a prior—employer's plan until no later than April 1 of the year after you finally stop working.

3Roth withdrawals are tax-free provided the account holder is over age 59½ and has held the account for five years or more.

4HSA withdrawals used for nonmedical purposes before age 65 may be subject to ordinary income tax plus a 20% penalty.

5Robert D Arnott, Andrew L Berkin, and Paul Bouchey, "Is Your Alpha Big Enough to Cover Its Taxes? Revisited," Investments & Wealth Monitor, 2011, pp. 6–10, 20.

6For 2023, to contribute to a Roth IRA, single filers must have a modified adjusted gross income of less than $153,000, and contributions are reduced starting at $138,000; for those married and filing jointly, the figures are $228,000 and $218,000.