Let’s fast forward to the future for this lesson.
At some point, you’re going to want to sell your investments and use the cash generated.
There are other situations where you’ll want to sell the fund and reinvest them, but we’re not going to touch on those topics right now. If you want to dig into them though, you can read more about tax-loss harvesting and tax-gain harvesting – two strategies to reduce your taxes in a taxable investing account.
When you sell funds in a 401(k) or a Roth IRA, you’ll pay no taxes – which is amazing. You can buy and sell funds in there to your hearts’ content (but I still recommend buying and holding long-term rather than speculating).
Once you’re ready to withdraw money from these accounts, that’s where things get interesting.
I’ve written some about my personal plan on how I’m withdrawing funds from my investment accounts on the Minafi Blog article: How We Plan to Spend $80,000 a Year & Pay Nearly $0 Taxes. In this lesson, we’re going to be exploring that works from scratch.
In all cases, we’ll use a withdrawal target of $100,000 a year. That’s more than most people will need, but it’s high enough to start posing some additional tax consequences.
Side note: we’re only talking about United States Federal Taxes as of 2020 here. No state taxes. Taxes often change slightly year to year, but the ideas should be the same for any taxes in the last 50 years (and hopefully the next 50 years too).
Roth IRA Only
Let’s start with the easiest case first: all of your money in a Roth IRA. You invest in Roth IRAs with after-tax money then withdraw money tax-free from them.
If you withdrew $100,000 from your Roth IRA, then your taxable income for the year would look like this:
| Type | Amount | Taxes [Jointly] | Taxes [Single] |
| Ordinary Income Total | $0 | $0 | $0 |
| Short-term Capital Gains | $0 | $0 | $0 |
| Tax-deferred Withdrawals | $0 | $0 | $0 |
| Long-term Capital Gains | $0 | $0 | $0 |
| Tax-free income | $100,000 | $0 | $0 |
| After-tax Amount | $100,000 | $100,0000% | $100,0000% |
Roth IRAs are easy – you can withdraw the money you put into them anytime tax-free, you can withdraw the growth in a Roth IRA after age 59 and a half, and there are no minimum required distributions later on. They’re amazing – use them if you can.
401(k) Only
401(k)’s are a tax-deferred account. That means that you pay taxes when you withdraw from them. The amount of taxes you are equivalent to how much you’d pay in federal taxes if you earned that income from a regular job – although you wouldn’t need to pay medicare or social security taxes as well.
[You can read about 2020s tax rates on TaxFoundation.org]
If you’re married and you withdraw $100,000 after age 59 and a half, then you’d pay taxes at the 22% level. What’s nice though is that you’d still get a standard deduction, which lowers your income by $24,800 – meaning that you’d only pay taxes on $75,200.
This means you’d pay 10% tax on the first $19,750 or $1,975. You’d pay 12% tax on everything else – from $19,750 up to $75,200. That comes out to $55,450 taxed at 12%, or $6,654. That would make your total tax bill $8,629 for the year. You would get to keep $91,371. That’s a 8.6% tax rate – not too bad!
| Type | Amount | Taxes [Jointly] | Taxes [Single] |
| Ordinary Income Total | $100,000 | $8,629 | $14,074.50 |
| Short-term Capital Gains | $0 | $0 | $0 |
| Tax-deferred Withdrawals | $100,000 | $8,629 | $14,074.50 |
| Long-term Capital Gains | $0 | $0 | $0 |
| Tax-free income | $0 | $0 | $0 |
| After-tax Amount | $100,000.00 | $91,371.008.6% | $85,925.5014.1% |
For this example and all examples in this lesson, we’re using the standard deduction. If you have enough deductions to itemize your taxes will be slightly lower.
If you withdrew more you’d pay more taxes with increasingly high rates. Taxes are progressive, so you’ll never pay JUST the top rate. For example, if you withdrew $1,000,000, you wouldn’t pay the 37% rate on all of that withdrawal. You’d pay it on all amounts over $518,400 or $622,050.
Brokerage Only
Brokerage accounts are entirely after-tax, which means you’d pay taxes if you sold the holdings. Taxes on brokerage accounts get a little confusing, so we’re going to cover all the potential ways you’ll be taxed.
What you pay taxes on within a brokerage account are capital gains. Capital gains are the growth of a fund since you purchased it.
If you bought a fund for $25,000 and later sold it for $100,000, then you’d pay capital gains on $100,000-$25,000 or $75,000 that you would pay capital gains on. The $25,000 you initially bought it for is called your “cost basis”, which is used to calculate your capital gains.
For those gains, there are two categories of taxes.
First, short-term capital gains, which are charged at the same tax rate as ordinary income like our 401k. Ideally, you want to avoid short-term capital gains whenever possible Short-term capital gains are charged for any fund you’re selling that you’ve held for less than 1 year. That’s based on the exact date you purchased the fund too, not the calendar year. So if you bought a fund on May 1st, you can sell it next year on April 30th, you’ll pay short-term capital gains tax. If you waited one more day to May 1st, you’d pay long-term capital gains instead.
Long-term capital gains have their own tax brackets and tax rates. There are fewer tiers than with ordinary income and with a much lower top tier.
What stands out about this is that there’s a 0% tax tier here. If you sold $39,375 in capital gains you’d pay $0 in taxes. It’s actually even better than that: since you get a standard deduction of $12,400, so you could sell $39,375+$12,400 or $51,775 in capital gains.
Now, that’s $51,775 in gains, not in total stock sales. If you invested in something and it doubled in value, that means you could sell $51,775*2, or $103,550 in stocks. In that case, you’d pay $0 in taxes!
There’s one issue with this plan though: dividends. Just about every fund gives off some dividends in the form of cashback into the settlement account of your investment account. When you’re growing your investments, you’ll usually want to set these dividends to “reinvest” back into the same fund or some other fund.
That’s all good, but it could mean that a small portion of your stock sale that was purchased with dividends would be considered short-term capital gains if you sold them. The recommended advice is that once you’re starting to sell and withdraw funds, it makes sense to switch your dividends to stay in cash rather than rebuy.
Situation: You bought $25,000 in stock, and sold it all years later for $100,000.
| Type | Amount | Taxes [Jointly] | Taxes [Single] |
| Ordinary Income Total | $0 | $0 | $0 |
| Short-term Capital Gains | $0 | $0 | $0 |
| Tax-deferred Withdrawals | $0 | $0 | $0 |
| Long-term Capital Gains | $75,000 | $0 | $7,140 |
| Tax-free income | $0 | $0 | $0 |
| After-tax Amount | $100,000.00 | $100,0000% 0% | $92,8607.2% 7.2% |
If filing taxes unmarried with $75,000 in gains, you’d pay about $7,000 in taxes. Not a massive tax hit, but still a few vacations worth.
Filing taxes jointly will lowe this all the way to $0! For the single case, you’re effectively paying this capital gains tax on $75,000 minus the standard deduction of $12,400. That means you’re paying it on $62,600.
When filing jointly the math works out even better. $75,000 – $24,400 comes out to $50,600. This still puts you in the 0% tax bracket for all of this amount!
The 2020 tax rate for staying at 0% for a couple filing jointly is $80,000. That means that you could sell $104,800 in capital gains and still pay $0 in taxes. Again, that’s how much you’d sell in capital gains – the actual amount of stock you sell would be higher than that and depend on your cost basis.
Multiple Accounts
Ok, those three cases assume you’re withdrawing from just one account. In real life, you’ll likely be getting money from multiple accounts each year – which can be the best way to draw down. Let’s look at one case that uses all three accounts.
| Account | Value |
| 401(k) | $1,200,000 |
| Roth IRA | $200,000 |
| Brokerage Account | $600,000 (cost basis: $200,000) |
| Total | $2,000,000 |
For this example let’s raise the amount you want to withdraw up to $150,000. Using the 4% rule you probably wouldn’t want to withdraw more than $80,000 in a given year, so withdrawing this much each year would exhaust your funds very fast.
Maybe you need to make a down purchase on house, money for college or some other large expense. What would be the most cost-effective way of withdrawing this money?
Our goal will be to pay $0 in taxes and to withdraw the minimum amount from our Roth IRA. We could just clean out our Roth IRA and call it a day, but there are better ways.
The capital gains in the brokerage account part are the hardest to calculate. Here’s how I think about: for every $1 you sell from that account, you’ll pay taxes on $0.66 cents of it.
If we withdrew all $150,000 from our 401(k) we’d pay a bunch of taxes – even for a married couple filing jointly. We could technically withdraw $150,000 from our brokerage account and STILL, pay $0 taxes though! There’s a reason we don’t want to do that though: the taxable order of accounts rule.
The taxable order of accounts rule says you should withdraw your money from the most tax-inefficient location whenever possible up to the limit where taxes kick in.
If we were to apply that to this scenario, we’d withdraw this much from each of our accounts:
| Account | Jointly | Single |
| 401(k) | $24,800 | $12,400 |
| Brokerage Account | $120,000 ($80k capital gains) | $60,000 ($40k capital gains) |
| Roth IRA | $5,200 | $77,600 |
| Total | $150,000 | $150,000 |
In both of these cases, the first thing we did was withdraw from our 401(k) up to the point where we’d have to start paying taxes – in this case up to the standard deduction. At that point, we’d still pay $0 in taxes.
Next, we withdrew from our brokerage account up to the top of the 0% capital gains bracket. We’d pay $0 on these capital gains.
Lastly, we use the Roth IRA to top our accounts up to the amount we need to hit our $150,000 target.
This is how we could do this, but in a real-world situation, I wouldn’t want to withdraw as much from my Roth IRA as in the “Single” case above. Doing that would narrow our ability to use the Roth IRA later on.
Instead, I’d likely withdraw another $60,000 or so from my brokerage account, and reduce the Roth IRA part. You’d pay taxes on $40k of capital gains at 15%, or about $6,000. $6k tax on $150,000 isn’t bad at all – a 4% tax rate!
Breaking it down like we did before, this is what the full-IRA approach would look like:
| Type | Amount | Taxes [Jointly] | Taxes [Single] |
| Ordinary Income Total | $24,800 jointly $12,400 single | $0 | $0 |
| Short-term Capital Gains | $0 | $0 | $0 |
| Tax-deferred Withdrawals | $24,800 jointly $12,400 single | $0 | $0 |
| Long-term Capital Gains | $120,000 jointly $60,000 single | $0 | $7,140 |
| Tax-free income | $5,200 jointly $77,600 single | $0 | $0 |
| After-tax Amount | $100,000.00 | $100,0000% | $92,8607.2% |
Again, in the filing single case, I wouldn’t recommend withdrawing that much from the Roth IRA, but it’s possible!
There’s one thing we’re not taking into account here: dividends. Chance are that during the year you withdrew these funds, you received some taxable dividends in the brokerage account. Assuming these are “qualified dividends”, they’ll be taxed at your long-term capital gains rate too. You could lower the amount withdrawn by the number of dividends you received.
Ok, that’s a lot. Let’s go ahead and review the top 3 main points.
#1, without a good tax strategy, you’ll most likely page more tax withdrawing from your 401(k) than any other account. Withdrawals from a 401(k) account are taxed at your ordinary income rate – which is usually MUCH higher than the capital gains rate you’d pay on after-tax investments.
#2, taxes on the sale of stock within a brokerage account is based on when you bought it (long-term capital gains or short-term capital gains). Whenever possible you should hold a fund long enough so that you’ll pay long-term capital gains rather than short-term gains.
#3, use the taxable order of accounts rule as a guide to withdrawing from your accounts. Certains accounts, like 401(k)’s and IRA, are less flexible than other accounts like Roth IRAs and even after-tax brokerage accounts. Withdraw from your 401k or IRA first if you can!
Understanding how taxes work with your investments can feel like a superpower. You begin to understand how all the pieces of your investment life fit together in a way that just works – enabling you to withdraw money at the lowest possible rates.