Episode 111: Be Tax Smart, Not Tax Scared
In this episode we discuss tax considerations for retirement savings
Transcript
Hello and welcome to the Balanced Wealth podcast. My name is Jarrett Topel.
Today I want to talk about something we see all the time with retirees and near-retirees. It is something I like to call tax paralysis. Tax paralysis happens when people have saved diligently for decades, often into 401(k)s, 403(b)s, traditional IRAs, SEP IRAs, SIMPLE IRAs, and other tax-deferred retirement accounts, but then hesitate to use the money once they retire.
They did exactly what they were supposed to do. They saved consistently, received tax deductions along the way, allowed the money to grow tax-deferred, and built a meaningful retirement nest egg. Then retirement arrives, and they finally have the time, money, and opportunity to do the things they always talked about doing. They may want to travel, help their children or grandchildren, remodel the house, buy a new car, take the whole family on a trip, or simply spend a little more freely after years of being careful. But then they realize that taking money from a traditional retirement account often comes with a significant tax-bill.
Suddenly, the decision becomes emotionally harder. A $25,000 family vacation may require a significantly higher IRA withdrawal. Depending on the family’s tax situation, they may need to withdraw closer to $35,000 or $40,000 dollars, or even more, to net the $25,000 they need after federal and state tax withholding. Even when the financial plan says they can afford it, and even when the numbers show that the withdrawal will not derail their retirement, the tax bill can make the spending feel just wrong.
It can feel like a penalty. But in most cases, it is not a penalty. It’s simply the second half of the bargain. When someone contributes to a traditional retirement account, they usually receive a tax benefit up front. The money goes in before taxes, grows tax-deferred, and then taxes are paid later on down the road when the money comes out of the account. That is not tax avoidance. That is tax deferral. This distinction is important because if people think of their retirement account as “tax-free money,” every withdrawal can feel painful. But if they think of it more accurately as “money that has not been taxed yet,” the tax bill may feel less surprising and less emotionally charged.
This is especially important today because retirement income planning has become more complicated. Required minimum distributions generally begin at age 73 for traditional IRAs and most retirement accounts, which means the IRS eventually requires money to come out whether the person needs it or not. For people who saved heavily into pre-tax retirement accounts, those required distributions can create larger taxable income later in retirement. At the same time, current tax rules still give savers several different account types to choose from.
So the planning question is not just, “How much should I save?” It is also, “Where should I save?”
That brings us to one of the most useful retirement planning concepts: the Tax Triangle. The Tax Triangle is simply a way of building retirement savings across three different tax buckets.
The first bucket is tax-deferred money. This includes traditional 401(k)s, traditional IRAs, 403(b)s, SEP IRAs, SIMPLE IRAs, and other similar accounts. These accounts can be very powerful because contributions may reduce current taxable income, and the money can grow without annual taxation. However, withdrawals are generally taxed as ordinary income. These accounts are often the backbone of retirement savings, but if almost all of someone’s retirement money is in this one bucket, they may have less flexibility later when taking withdrawals.
The second bucket is taxable money. This includes individual accounts, joint accounts, community property accounts, trust accounts, and other non-retirement investment accounts. These accounts do not usually provide an upfront tax deduction, but they can be very useful in retirement. When money is withdrawn from a taxable investment account, the entire withdrawal is not necessarily taxable. Part of the withdrawal may simply be a return of the individual’s own principal. When there are taxable gains, long-term capital gains are often taxed at more favorable federal rates than ordinary income. This can create more flexibility when deciding where retirement income should come from.
The third bucket in the tax-triangle is tax-free money, most commonly Roth accounts. With Roth IRAs and Roth 401(k)s, the contribution does not usually receive the same upfront tax deduction, but qualified withdrawals may be tax-free later. Roth money can be especially valuable in retirement because it may allow people to fund larger expenses without increasing taxable income.
The point is not that one bucket is always better than the others. The point is that having all three can give you choices and flexibility. And choices and flexibility are what often help best to reduce tax paralysis.
For example, let us say a retired couple wants to spend an extra $50,000 one year. Maybe it is for travel, helping a child, making a home improvement, or covering an unexpected expense. If all of their money is in a traditional IRA, the entire withdrawal may be taxable as ordinary income. But if they have a mix of accounts, we may be able to pull some from the IRA, some from a taxable account, and some from Roth money. That may help manage the tax impact and make the decision feel less painful.
This is where tax planning becomes emotional planning, too. The goal is not simply to pay the lowest possible tax in any one year. Sometimes the goal is to create a retirement income strategy that people can actually live with. A strategy that lets them say yes to the family trip. Yes to helping the grandkids. Yes to replacing the old car. Yes to spending a little more while they are healthy enough to enjoy it.
This does not mean taxes don’t matter. They absolutely do. Good planning can help manage tax brackets, required minimum distributions, capital gains, Roth conversions, charitable giving strategies, and withdrawal sequencing. But taxes should not be the only thing driving the decision. A perfect tax strategy that prevents someone from enjoying retirement is not really perfect.
We often encourage clients to think about taxes as part of the cost of success. If you are paying taxes, it usually means you made money, saved money, or built something worth taxing. That does not make taxes fun, but it can make them feel less like punishment.
For people who are still working and still saving, the takeaway is especially important. Don’t just ask, “Am I saving enough?” Ask, “Am I saving into the right mix of accounts?” Should some money go into pre-tax retirement accounts? Should some go into Roth accounts? Should some go into a regular taxable investment account?
We can’t know exactly what tax rates will be 10, 20, or 30 years from now. We can’t know exactly what each person’s income will look like in retirement. We cannot know exactly what Congress will do. But we can build flexibility. And flexibility is often the best defense against uncertainty.
So, if you are approaching retirement, or already retired, and find yourself hesitating to spend because of the tax bill, take a step back. Ask whether this is really a tax problem, or whether it is a mindset problem. Ask whether the withdrawal actually puts the plan at risk, or whether it just feels uncomfortable because taxes are involved. Most importantly, ask: What was this money for in the first place? For many people, the goal was never just to build the biggest account balance possible.
The goal was security. The goal was freedom. The goal was taking care of family. The goal was enjoying life.
The right tax strategy should support those goals, not get in the way of them.
And that, my friends, is the heart of Balanced Wealth.
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