Learn how tax-savvy withdrawals in retirement, with strategies for sequencing, Roth conversions, RMDs, and more, can reduce your lifetime tax bill.
Quick takeaways
You spend your lifetime building up your retirement savings. Once you hit the post-work years, how do you figure out a strategy to withdraw it and minimize taxes, too? Here’s some help to get started.
You may have saved in different types of investment accounts. How you withdraw from your retirement savings matters, and not just to help pay your expenses in retirement. Without a retirement withdrawal strategy, you may be blindsided by unexpected tax bills which could impact the income you have during retirement.
During retirement, you don’t have to withdraw your savings from just one account at a time. Instead, a thoughtful retirement withdrawal strategy helps you plan out how much and from where you withdraw savings. It also takes into account your current and future tax brackets, required minimum distributions (RMDs), the impact of withdrawals on Social Security and Medicare, and your retirement goals, too.
In general, in retirement you may withdraw from three different retirement income sources. Each is taxed differently.
| Retirement savings account | Tax impact on withdrawals |
|---|---|
| 401(k), 403(b), traditional IRA | Tax deferred: You pay income taxes in retirement. |
| Roth (includes 401(k) and IRA), HSAs | Tax free: You pay no income taxes in retirement. |
| Savings and brokerage accounts | Taxable: You pay capital gains taxes, which vary based on amount and account type. |
One of the most widely used retirement withdrawal strategies is to take money out from one type of account at a time, typically beginning with taxable before moving on to tax deferred and tax free. Once funds from one source are depleted, you then move onto the next source.
The logic behind this is has two main components. First, because you spread out your withdrawals from that taxable account over time, you may minimize the taxes you pay at the start of retirement, pay the most income taxes in the middle of retirement, and owe little to no taxes at the end. Second, tax-deferred and tax-free accounts may continue to grow.
Let’s look at a simple example: Matt and Jen, a retired couple, file their taxes jointly and retire at age 65. Until they reach age 73, they withdraw $84,000 from a brokerage account and pay 0% in capital gains tax. At age 73, they begin making withdrawals from 401(k)s. In the last years of retirement, they withdraw from Roth accounts.
| Retirement years | Yearly withdrawal source and amount | Yearly income tax due |
|---|---|---|
| Years 1-7 | Brokerage account; $84,000 | $0 (below capital gains threshold) |
| Years 8-15 | 401(k): $84,000 | $9,616 |
| Years 16-22 | Roth: $84,000 | $0 |
But there’s another retirement withdrawal strategy to consider: proportional withdrawals from each type of accounts during each year of retirement.
This technique is much like it sounds: Once you decide how much retirement income you need, you withdraw it proportionally from your various retirement savings. For example, if you have 50% of your total savings in a 401(k), 20% in a Roth, and 30% in a brokerage account, you’d withdraw 50% of what you need from the 401(k), 20% from the Roth, and 30% from the brokerage account.
The logic with this strategy is to spread potential income taxes over time, instead of bunching them in a particular phase of retirement. It’s especially appealing to those who may not have a lot of capital gains taxes, allowing them to spread out those funds over time, while also minimizing ordinary income taxes.
Let’s look at another simple example with the same retired couple, Matt and Jen, who file taxes jointly and retire at age 65. Their yearly budget is $84,000; they have 50% of retirement savings in 401(k)s, 20% in a Roth, and 30% in a brokerage account.
| Retirement years | Yearly withdrawal source and amount | Yearly income tax due |
|---|---|---|
| Years 1-22 | Brokerage account: $42,000 | $0 (below capital gains threshold) |
| 401(k): $25,200 | $6,378 | |
| Roth: $16,800 | $0 |
There’s one other thing that developing a retirement withdrawal strategy can help with: the early retirement gap.
Let’s say you’ve decided to retire at age 57, but you can’t withdraw from retirement accounts until age 59½. You’re also not planning on signing up for Social Security benefits until age 67. That gap from age 57 to 59½, and then to age 67, is what’s known as the early retirement gap.
Actively planning for those years may help you lessen future tax obligations. For example, you could complete Roth conversions (see below) or withdraw, penalty-free, from a health savings account for eligible expenses.
Your retirement income withdrawal strategy also impacts potential taxes on Social Security benefits as well as how much you pay in Medicare premiums.
Whether or not you pay income tax on Social Security benefits depends on what’s called your combined income: adjusted gross income plus nontaxable interest plus half your Social Security income. If you are married and filing jointly with a combined income of less than $32,000, none of your Social Security benefit is taxed.
If it’s more than $44,000, up to 85% of your Social Security income is taxed. For the purposes of Social Security benefits taxes, IRAs are included in your income, while Roths are not. So, if you withdraw some income from an IRA before you elect to receive your Social Security benefit, you may avoid tax on the latter.
And then there’s the Medicare income-related monthly adjustment amount, or IRMAA. The higher your modified adjusted gross income (MAGI), the higher your Medicare premiums may be for Parts B and D.The IRMAA adjustment is calculated based on your MAGI not from the current year, but from two years ago, and is not permanent.
Beginning at age 73, you must take RMDs from tax-deferred accounts such as 401(k)s. RMDs are calculated based on the account balance and a life expectancy factor, and those withdrawals are subject to income tax. If your balances in those account types are high, there’s a potential for you to be a higher tax bracket, too. Both Roth conversions and qualified charitable distributions (both detailed below) as well as an overall tax strategy can help.
A retirement withdrawal strategy is like a big puzzle. One piece to consider is whether a Roth IRA conversion makes sense for your retirement tax strategy.
Here’s what a Roth conversion is: If you have funds in a traditional IRA or 401(k), you can convert them into a Roth version of the account, either all at once or over time. In doing so, you’re obligated to pay the income tax bill at the time of conversion. But, because Roth accounts don’t have RMDs, you’ll lower (or even eliminate) the tax bill when you take distributions—especially helpful if you think you’ll be at a higher tax rate.
While there’s no limit on the amount you can convert to a Roth, keep in mind you are responsible for the tax bill at the time of conversion. And, if you aren’t yet age 59½, you must keep the converted funds in the new account for five years, or face penalties.
There’s another tax-saving strategy to consider in your retirement withdrawals: qualified charitable distributions (QCD). These allow you to transfer a certain amount (currently $11,000) directly from an IRA to a charity after age 70½. Those funds are not considered taxable income, but do help you meet your RMD requirement for the year.
Developing a retirement withdrawal strategy takes time and effort—and can be complicated. Both a financial professional and a tax adviser can serve key roles for you, helping you navigate pre-retirement years and through retirement, too.
Need help finding a financial professional? Check with your HR contact to see if your company’s retirement savings plan offers financial professional services.
