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Which Accounts Should You Draw From First in Retirement?

Which Accounts Should You Draw From First in Retirement?


A Tax-Efficient Withdrawal Strategy Could Prolong The Useful Life Of Your Assets By Six Years Or More. *


Retirement planning goes beyond making sure that you save enough money.  Many people save enough, but then withdraw the money incorrectly during retirement.  By not taking the tax liabilities into consideration, many people deplete their retirement savings long before they would with a tax-efficient strategy.

While there is no "one-size-fits-all" approach that applies to every person, there are certain factors that every retiree should consider when they are choosing how to use their retirement funds.

 Every retiree should have the same goal – minimizing taxes.  Your tax brackets will likely change dramatically once you are in retirement and probably even a few times throughout retirement.  Therefore, whether you have money in traditional and/or Roth IRAs, 401Ks, or  in non-retirement accounts,  you should understand how your accounts affect your tax liabilities.

  Before you withdraw from your retirement funds, consider the following guidelines.  

Creating Your Retirement Withdrawal Strategy 

Determine Your Floor 

Your floor is the guaranteed income you will receive.  Social security payments are a vital component of the guaranteed income that most people will receive in retirement.   Other sources of guaranteed income typically come from pensions or annuity payments.  Once you determine your floor, you will then need to compare it to your overall income needs.   

For example, let’s say you receive $30,000 a year in Social Security; and you have $10,000 coming in annually from an annuity, but you need $90,000 each year to maintain your lifestyle. As a result, you will have a $50,000 deficit that you will need to meet from your savings. 

First, you will want to consider how the income being generated from your guaranteed sources will be taxed. 

For example, you will never pay taxes on more than 85% of your Social Security Income.   The amount of tax that you owe on annuity income varies depending upon the type of annuity and whether it was held inside or outside of a retirement account.  Pension income is normally taxed at ordinary income tax rates.  Understanding the tax implications of your guaranteed income sources is your first step. This information will help you determine how to optimize your additional withdraws from a tax perspective. 


Proportion Your Retirement Withdrawals 

Rather than looking at one account at a time, consider the big picture approach.  The traditional retirement withdrawal strategy looks like this: 

  1. Deplete taxable accounts (non-retirement accounts)
  2. Use tax-deferred accounts (retirement accounts like IRAs or 401Ks)
  3. Finally, access tax-free accounts (Roth IRA, Roth 401K, HSAs)

Upon retirement, the retiree would exhaust his/her taxable accounts, then the tax-deferred, leaving the tax-free accounts for last. This makes sense initially. However, this strategy does not take into consideration the combination of social security income and required minimum distributions (RMDs) that will kick in later in life. Together, these multiple income streams could place you in a higher tax bracket than you anticipated once you are well into your retirement years. 

An alternative strategy would be to withdraw from both retirement and non-retirement accounts simultaneously, so that you begin to draw down your retirement accounts early, decreasing the future tax liability.  If you structure your withdrawals so that you take the largest withdrawals from your retirement accounts during years that you are in the lowest tax bracket, then you will minimize your tax liabilities. 

This may mean that one year, you withdraw heavily from your taxable accounts and not so heavily from the tax-deferred accounts; while in another year, it may be the other way around.  As long as you pay close attention to avoiding the RMDs which cause taxes to be forced upon you, the strategy should save you money.  

Here is an example:

Lets consider a retired, married couple.  They are 60 years old; and they are in need of $90,000 per year to maintain their lifestyle.   They have $300,000 in their taxable account, $1,500,000 in their 401Ks and $150,000 in a Roth IRA account.  According to the table below, this should place them in the 22% tax bracket ( see Table 1. All income over $80,250 is taxed at 22%). 

Table 1. 2020 Tax Brackets and Rates
RateFor Single Individuals, Taxable Income OverFor Married Individuals Filing Joint Returns, Taxable Income OverFor Heads of Households, Taxable Income Over
10%$0$0$0
12%$9,875$19,750$14,100
22%$40,125$80,250$53,700
24%$85,525$171,050$85,500
32%$163,300$326,600$163,300
35%$207,350$414,700$207,350
37%$518,400$622,050$518,400

Source: Internal Revenue Service


Because they are only age 60, they have not started social  security. They also have not started taking required minimum distributions.  Thus, they have no income sources that are forcing them into a higher tax bracket right now. 

Because they both worked full time, and plan to delay social security until they are age 70, their combined  social security payments are expected to be over $90,000 per year (assuming the 2020 maximum social security benefit of $3,790 per month per person for those starting at age 70).   Once they reach age 72, because their IRAs have grown over the years, their RMDs are expected to be over $100,000 annually. (Trust me here, the math on this is beyond the scope of this blog).  

This will give them a combined income (social security plus RMDs) of approximately $200,000 per year or more.   This would thrust them into the 24% tax bracket given the current tax law. Many experts expect tax rates to increase in the future due to the deficit being accumulated in this country, so their tax burden may be even greater. 

It may make sense to take advantage of their relatively lower tax brackets now, by partially funding the early years of their retirement from the IRA account.  This will increase their tax liability today, but lower the amount in the IRA over time - which will trigger a smaller RMD in the future.   Executing this strategy takes very detailed planning. If done properly, this strategy could reduce their lifetime tax liability, and thus prolong the useful life of their assets. 

Diversify Your Retirement Income 

In order to have the flexibility of a more tax efficient withdrawal strategy, you need to be mindful of which accounts you contribute to long before you retire.  Many people make the mistake of only contributing money to their retirement accounts because of the tax break they receive when they make their contributions.  Decide whether it makes sense to only contribute to your retirement accounts or to also put money away outside of those vehicles.    

It all comes down to when you pay the taxes on your investments.  Is it better to delay the taxes, paying them during retirement when you need money the most, or pay them now and let your earnings grow tax-free? 

The best strategy must be determined on a case-by-case basis, but everyone should diversify no matter their strategy.  This means having accounts in all of the following buckets: 

  • Taxable account (traditional brokerage account)
  • Tax-deferred account (IRA ,401K or 403B)
  • Tax-free account (Roth IRA) 

Segmenting Your Retirement Funds

While it is important to diversify your accounts, it is also important that you maintain your asset growth throughout retirement. Create a strategy that has the following options: 

  • Liquid funds – These funds should be immediately available. Cash or bond funds are a great option.  Neither investment will offer much growth but they will always be available; and accessing them results in  little to no tax liability if/when you need these funds. 
  • Short-term funds –  This is money that you will need in the next 3 to 10 years.  While you do not want to get super aggressive and risk losing your money, you want it to grow a bit, helping to further increase your retirement funds.  Depending upon your tax bracket, tax-free bonds may make sense to add to this bucket in order to help manage your tax liability.  You may also consider allocating a portion to high-yield bonds or alternative investments to help augment your income.  The goal is to generate as much income from this bucket as possible, to help supplement your current needs.  This income should be available, even when the stock market is down.
  • Long-term funds – These are funds that you do not need for 10 or more years.  For this bucket, invest heavily in stocks or in more aggressive funds so that you continue to grow your nest egg and further increase your retirement income.  If the stock market does unusually well in a given year, that may be the opportune time to sell stocks that you have held for over one year at a gain (long-term capital gains tax rates are typically lower than ordinary income tax rates) to fund your living expenses.  

Avoid Required Minimum Distributions (RMDs)

If you have an IRA, 401K or 403B, you must take required minimum distributions (RMDs) once you reach age 72. This can greatly inflate your tax liabilities if you do not structure these distributions properly. To avoid an unexpected hike in tax liabilities, devise a strategy for taking withdrawals from your tax-deferred accounts.  

You can do this in a few ways.  One way is to withdraw from the tax-deferred accounts regularly when you are early in retirement (highlighted in the previous example).   Large RMDs are a primary reason why you may end up in a much higher tax bracket than you anticipated.  These distributions can deplete your funds faster than necessary and cause you to lose more of your hard earned savings to Uncle Sam.  

Another option, which requires the help of an advisor, is to convert your traditional IRAs or 401Ks to a Roth IRA account. Timing this just right can help minimize your tax liabilities. Take note, though: when you convert to a Roth, you trigger a tax liability. You will owe taxes on the amount that you convert .  However, if you do this during a time when you have little to no tax liability, then you will build up money in your Roth IRA which can then be withdrawn tax-free in the future.   A great time to do this is during the early years of retirement, before you start withdrawing your social security funds and before you start your RMDs. 

Take Advantage Of Tax-Free Capital Gains 

Did you know that tax-free capital gains were available? If you do not exceed the taxable income limits, your long-term capital gains and some dividends do not trigger a tax liability.  

As of 2020, if your income is less than $40,000 for single filers and $80,000 for couples filing jointly, you may  sell some of the investments in your taxable accounts,  paying no taxes on your capital gains.  

If you supplement these capital gains with tax-free Roth IRA distributions, you will not trigger a tax liability. 

Be Flexible With Your Withdrawals

No two years will look the same.  Your expenses vary in retirement much as they do while you are working.  

Try to look at one year at a time, creating a monthly retirement withdrawal strategy that you can stick to or change if necessary.  For example, if you have a year when your living expenses are lower than other years, it is a good time to analyze the optimal way to fund your expenses for that year.  Would you make out better drawing from a retirement account and paying tax at your income tax rate? Or might you be able to take advantage of 0% capital gains in your non-retirement accounts this year?  The best strategy depends on what your tax situation is this year, and what your tax liability is expected to be in the future.

Don’t Wait Until You’re Close to 72 

Here’s the key:  Waiting until you are in your 70's to create a retirement withdrawal plan is too late.  At that point, you will have required minimum distributions forced upon you and you will have little control over your tax liabilities. 

Instead, create your retirement planning strategy long before you even retire. Look at your plans – what do you see yourself doing? What lifestyle will you have? How will things change? 

Use those plans to create your withdrawal strategy so that it reflects your needs while minimizing your tax liabilities. 

No one knows exactly what to expect when retirement planning, but having a plan is essential.  Outliving assets is something most retirees worry about, especially with longer life expectancies today.  With a combination of your retirement savings, non-retirement accounts and guaranteed income, you should be able to maximize your retirement earnings, limit your taxes, and get the most out of your retirement funds to benefit you and your loved ones.  It all starts with a detailed retirement plan, focusing specifically on your draw down strategy, to help prolong the useful life of your assets.  

 *The American College of Financial Services