An Advisor’s Guide to Understanding Retirement Taxation and Allocation

The national debt is growing and that means that tax rates are most likely to continue to rise from here. Taxes can have a huge impact on retirement accounts, cutting into a retiree’s income significantly if not accounted for and managed correctly. Understanding the different tax-structured accounts and what kinds of assets go into each is more important than ever for advisors.

The U.S. national debt was 100% of GDP in 2021 according to the Government Accountability Office, and is estimated to rise to a record 107% of GDP by the end of 2028: the highest that the national debt has ever been historically was post-World War II when U.S. debt to GDP hit 106%.

This means that tax rates are very likely to continue to rise from here and while it's unlikely that the Biden administration will be able to pass through higher income taxes for the top income brackets given the current divided political climate, the current Tax Cuts and Jobs Act (TCJA) is set to expire at the end of 2025.

TCJA created larger standard deductions for everyone, with greater benefit to those 65 and older, and estimates put about 90% of taxpayers utilizing the standardized deduction on tax returns over itemized deductions. The increased standardized deductions also allow for a greater amount of withdrawals from tax-deferred retirement accounts and should the TCJA expire, and no replacement be put in place, the tax impact on retirees would be significant.

“As we look at the tax landscape for the foreseeable future, the one thing we can say with the most confidence is that tax rates are unlikely to go down. Given the intense, persistent pressure of the national debt, the reality is that the next few years could end up being a low point for federal income tax rates,” explained Doug Ewing, JD, CFP, RICP, Western region for the Nationwide Retirement Institute, in a recent Nationwide blog post.

Understanding the Way Accounts Are Taxed

There are three primary types of accounts when it comes to taxation: taxable accounts, tax-deferred accounts, and tax-free accounts.

  • Taxable accounts are accounts where withdrawals and earnings to the account accrue taxes in the year that they were done. Investors pay taxes on dividends, interest, capital gains, and other qualifying tax events under the default tax rules. Examples of a taxable account are anything from a checking or savings account to money market accounts and more. The benefit to taxable accounts is that there is no limit on contributions and no hoops to jump through when it comes to withdrawals.
  • Tax-deferred accounts are accounts where income is deposited that can then be written off of the investor’s taxable income for the year, with taxes realized on the contribution and related returns when the money is withdrawn, typically in retirement, though this does vary by account type. Examples of a tax-deferred account include an Individual Retirement Account (IRA), 401(k)s, tax-deferred annuities, and more. Benefits to a tax-deferred account are that investors can put money away for retirement, actively grow that money with contributions, and reduce the amount of taxable income they are accountable for each year pre-retirement.
  • Tax-free accounts work somewhat the opposite way to tax-deferred accounts: investors pay the taxes upfront with after-tax money so that withdrawals made later in retirement are done tax-free. Examples of a tax-free account include Roth IRAs and Roth 401(k)s. Benefits to a tax-free account include having access to both the contributions made and any returns they generate without worrying about taxes, particularly appealing in a time when future taxation rates look to be higher.

Tax-deferred and tax-free accounts do come with limitations, both on the amount that can be contributed to them as well as how much can be deducted depending on an individual client’s income bracket. It is necessary to understand the IRS limits on each so that advisors can help their clients maximize their tax savings across all accounts and asset types.

There is a lot of complexity that goes into determining which accounts are best for each client’s retirement goal and plan and how money should be allocated into each account. While a mixture of accounts is typically utilized in a retirement plan, younger clients benefit more from tax-free accounts that can take advantage of the lower tax brackets they typically are in, while high-income clients benefit from more allocation to tax-deferred accounts where they can realize the tax benefits each year from contribution write-offs. Taxable accounts are best suited for emergency needs and savings for purchases such as new vehicles or a house because of the flexibility they provide.

“Having a mix of non-qualified taxable assets, tax-deferred retirement accounts, and potentially tax-free accounts can allow retirees the flexibility they need to actively manage their tax liability in retirement, and possibly avoid higher tax rates should they come to pass,” Ewing explained.

For more news, information, and strategy, visit the Retirement Income Channel.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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