Tax-Efficient Retirement Withdrawal Strategy

When you stop working and have to start withdrawing money from your retirement accounts, you have to decide the best way to withdraw money from different accounts. Do you take money out of your tax-free accounts like Roth IRA and Roth 401(k) first? Or do you withdraw from your tax-deferred accounts like Traditional IRA and 401(k) first? What about the money in your normal taxable accounts?

Having the right withdrawal strategy in place can help you minimize your taxes and maximize the money you can leave for your beneficiaries.

The Three Types of Investment Accounts

When you first start your career, it makes sense to contribute to a Roth IRA and Roth 401(k) because you will be in a lower tax bracket. Plus, after your income rises to a certain point, you won’t be able to contribute to a Roth IRA at all, so it makes sense to contribute while you can.

As your income and taxes rise, you might switch to a Traditional IRA and 401(k) to get a tax break today, but pay taxes on your withdrawals in retirement. As your income and thoughts on taxes change throughout life, you might even consider investing in both in the same year.

All these changes mean you can end up with many accounts to choose to pull your retirement income from. Which account do you tap first?

In the Asset Location article, we covered the three types of investment accounts. Here we will focus specifically on how to manage these accounts through your retirement.

Tax Brackets and the Tax Sweet Spot

To figure out the best strategy, you have to take into account various tax brackets. You should familiarize yourself with the three charts below.

For most people, the sweet spot is highlighted in yellow.

• For a single filer, you want to keep your taxable income below $39,375.
• For a married couple filing jointly, you want to keep your taxable income below $78,750.

By doing this, you can liquidate investments in taxable accounts at a long-term capital gains tax rate of 0% and keep your maximum marginal tax rate at 12%. If you don’t pay attention to this number and you exceed the capital gains tax limit, then all of your capital gains are taxed at 15%. This could be a $10,000+ mistake, and it can make a huge difference!

Long-Term Capital Gains Tax Rates (2019)

Source: IRS.gov

Federal Income Tax Rates (2019)

Source: IRS.gov

Social Security Benefits Subject to Tax (2019)

Source: SSA.gov

Tax-Efficient Retirement Withdrawals

With your nest egg split between tax-free accounts, tax-deferred accounts, and possibly, outside of retirement accounts; how should you withdraw your money?

In this discussion, we will assume you have money spread across all three types of accounts. Also, we will assume that you need to withdraw money from your accounts and that you will withdraw 4% or less from your total savings each year.

Non-Retirement Savings Income Sources

First, you must account for all other incomes that you’re getting. These incomes include Social Security benefits, pensions, rental income, investment income from your taxable accounts, part-time jobs, business income, etc. You want to use these incomes first before tapping your savings.

TIP: Any money you can save will help you stretch your savings and possibly reduce your tax burden by keeping you in the lower tax bracket.

Conventional Withdrawal Sequence

The traditional retirement withdrawal strategy is to withdraw from your taxable account first because long-term capital gains from the sale of investments inside your taxable accounts are at a favorable tax rate depending on your taxable income (see tax table above). Secondly, this allows your tax-free and tax-deferred accounts to keep growing.

Specifically, the withdrawal sequence looks something like this:

1. If you’re 70½, take your Required Minimum Distribution (RMD) from your tax-deferred accounts, or you’ll be penalized. It is generally not worth paying the penalty.
2. Use your non-retirement savings income sources.
3. Use dividends and interest payments income (or cash) in your taxable accounts. You already owe tax on this year’s earnings, and cash withdrawal from these accounts do not count against your taxable income.
4. If you’re 59½ and have large tax-deferred savings in Traditional IRA and 401(k), consider withdrawing money from this source next (see special considerations below)
5. Sell assets inside taxable accounts while keeping the long-term capital gains tax rate at 0%.
6. If you still need more money, you might consider withdrawing from your Roth accounts. These withdrawals do not increase your taxable income.

Remember, you don’t have to do all of the steps, just do enough to cover your expenses.

Special Considerations

There are several considerations you want to take into account to make the most of your retirement savings and your legacy.

1. Early Retirement

If you retire before you turn 59½, do not withdraw from your tax-deferred or tax-free accounts because doing so will incur a 10% early withdrawal penalty.

The only exception would be the IRS Rule of 55, which allows you to pull money out of your current 401(k) or 403(b) plan without penalty if you were laid off, fired, or quit between the ages of 55 and 59½. This applies to employees who leave their jobs anytime during or after the year of their 55th birthdays.

2. Large Tax-Deferred Savings

If you ended up with most of your savings inside your tax-deferred accounts, you should calculate your RMD as you approach 59½. You can use a calculator like this one at Schwab.com to see what your RMD will be at 70½. The RMD is based on your total savings across all of your tax-deferred accounts.

If you’re a single filer with a total savings of more than $700,000 (resulting in an RMD of $25,547.45) or a married couple filing jointly with a total savings of more than $1.4 million (results in an RMD of $51,094.89), you might want to withdraw from tax-deferred accounts first. This reduces the chance of your RMD pushing you above your tax sweet spot when you turn 70½.

3. Not Taking Capital Gains

If your RMD is going to bump you into the next tax bracket causing you to lose the 0% long-term capital gains tax rate, you could consider not liquidating any asset in your taxable accounts to avoid paying 15% taxes.  For each year that you are doing this, you would withdraw exclusively from your tax-deferred accounts, and if needed, your Roth accounts.

This strategy is actually beneficial for your heirs. When they inherit assets in your taxable accounts, they have the benefit of step-up in cost basis which minimizes their tax burden. Whereas they have to pay ordinary income taxes for distributions from your tax-deferred accounts (see Estate Planning below).

4. Asset Location

Hopefully, you’ve been practicing Asset Location throughout your investing career. If you haven’t, and your taxable accounts are producing an excessive amount of taxable interest and dividend income, you might consider changing to more tax-efficient investments.

This might be a little challenging to do because you want to keep your taxable income under the sweet spot and maintain a proper asset allocation.

5. Roth Conversion

If your taxable income is below the tax sweet spot, you might consider converting some of your Traditional IRA into Roth.

The conversion increases your taxable income. Your goal is to convert as much as possible without going over the tax sweet spot to keep your capital gains tax rate at 0%. You will be paying 12% federal income tax on the converted amount when you do this. The primary benefit for this technique is your beneficiaries do not have to pay income taxes on the Roth savings you leave behind for them.

However, this requires the exact calculation, and you will want to get a competent tax advisor to help you with this advanced technique.

6. Tax-Loss Harvesting

If your capital gains and taxable income are pushing past the sweet spot, you could look into your taxable accounts to see if there is any tax-loss harvesting opportunity. Remember you can use tax-loss to offset your capital gains, plus up to $3,000 of ordinary income.

7. Estate Planning

Assets in Taxable Accounts

If you plan to leave unused savings for the next generation, any assets in your taxable account will be subject to the standard estate and inheritance taxes. The good news is your heirs get a step-up in basis when they inherit assets from your taxable accounts. This means the cost basis is adjusted based on when the heirs acquire the assets and not your original cost basis. For the surviving spouse, you only get a 50% adjustment base on your spouse’s half of the assets.

For example, if you bought a stock at $2 a share and today’s price is $102 a share, you’d owe $100 in capital gains if you were to sell the share. However, your beneficiaries’ cost basis is adjusted to $102 when inherited, and they only pay capital gains based on the adjusted basis.

Assets in Retirement Accounts

From your retirement accounts, your spouse could simply assume ownership of your accounts. For your non-spouse beneficiaries, each inherits the designated amount from each account. That money has to be placed into an Inherited IRA, and the recipient can elect to distribute the funds (1) in lump-sum, (2) spread across 5 years, or (3) spread across the lifetime (using an IRS provided life expectancy table).

• Distributions from Roth IRA and Roth 401(k) are tax-free for your beneficiaries.
• Distributions from Traditional IRA and 401(k) are taxable at your beneficiaries’ ordinary income tax rate.

TIP: Do not plan to minimize inheritance tax unless you are 100% certain that you will have money to last you a lifetime; otherwise, it is better to reduce your own taxes and stretch your savings.

Bottom Line

The most optimal and tax-efficient retirement withdrawal depends on many factors, and it is a complicated matter. This article only gives you a general idea of the strategy and sequence of withdrawal, along with special considerations that you should take into account. However, this is something that a competent tax advisor will more than pay for itself. Over the course of your retirement, having the right withdrawal plan can save you thousands in taxes and stretch your savings for longer.

Pinyo Bhulipongsanon

Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.