As you approach retirement, it’s important to develop a retirement income strategy. Developing tax-efficient retirement withdrawal strategies to plan your income stream should be an annual process. Each year your taxable income will change, and potentially your living expenses. The tax code has also changed repeatedly in the last 10 years, so it’s important to make sure your withdrawal strategy is current with the latest rules.
Retirement Income Strategies: How Different Accounts Are Taxed
Retirement funds are typically held in three different types of accounts:
- Tax-deferred (pre-tax IRA, 401(k), 403(b), etc.)
- Tax-free (Roth IRA and other Roth accounts)
- Taxable account (brokerage account)
The retirement drawdown strategies available to you will depend on how diversified you are from a tax perspective. Having considerable retirement savings in each type of account will generally yield more planning opportunities.
Tax-deferred accounts include traditional IRAs and pre-tax 401(k) plans. These are called tax-deferred because (as the name suggests) taxes are deferred until the money is withdrawn. So when you make a withdrawal in retirement, the entire amount is taxed as ordinary income. Tax-deferred retirement accounts also have required minimum distributions (RMDs) which must be included in retirement income planning discussions.
Tax-free accounts include the Roth IRA, Roth 401(k), and other types of Roth accounts. As long as investors meet the five-year required holding period and delay distributions until after age 59 1/2, withdrawals are tax free.
A brokerage account is a taxable investment account. While not a retirement account, a brokerage account is commonly used by affluent investors to supplement retirement savings. In brokerage accounts, there is no tax deferral, so capital gains, interest, and dividends are subject to tax each year. You’ll likely owe some tax annually even without a withdrawal, but by holding positions for more than a year, you can benefit from favorable long-term capital gains rates.
Having assets in all three types of accounts provides opportunities to create tax efficient retirement withdrawal strategies.
Tax-Efficient Withdrawal Strategies In Retirement
The best way to meet your income needs in retirement is a blend of art and science. Consider all factors relevant to your situation as well as your long-term goals.
Consider this illustrative example and corresponding tax-efficient retirement withdrawal strategies.
Couple age 60 with significant taxable and tax-deferred retirement savings
The couple has options. They can generate retirement income from their brokerage, pre-tax IRAs, or both. Required minimum distributions don’t start until age 75 for these retirees. In the traditional rule-of-thumb, the couple would first spend down their taxable assets before tapping retirement accounts.
But is that really the most tax efficient withdrawal strategy?
In doing so, they would likely be setting themselves up for a major tax hit when RMDs started. Large, forced distributions would give them few places to hide from a tax standpoint. Further, they might be missing opportunities between now and then to take advantage of low tax years.
Instead, the couple could consider one or more of the following approaches each year:
- Take dividends and capital gains distributions in cash versus reinvested shares
- Evaluate their tax situation annually and start withdrawing funds from pre-tax assets to take advantage of low tax brackets and control entry into the next higher tax bracket
- If there are additional income needs, further analysis is needed. Consider what asset classes need to be rebalanced, the expected taxable income for the year, relative split between account types, and unrealized capital gains to make a determination
Other withdrawal strategies to consider when cash flow needs are met
If generating additional income isn’t necessary, consider the merits of doing a Roth conversion in any given year. Roth conversions are very flexible so it’s possible to only convert enough to fill up the current marginal tax bracket.
Also consider the pros and cons of taking profits from taxable accounts to fill up the 0% capital gains tax bracket. In 2024, married couples filing jointly can have income up to $94,050 and pay 0% on long-term capital gains.
Tax Deferred Accounts Aren’t The Most Efficient For Every Goal
If one of your main goals is to preserve your wealth for your children, the best withdrawal strategy for your objectives might not be the most tax efficient.
Non-spouse beneficiaries can no longer stretch an IRA over their lifetime. Instead, they must take the entire account within 10 years and may be subject to annual RMDs also. For beneficiaries in their prime working years, this could significantly complicate their tax situation. Forced withdrawals may also encourage spending.
By drawing more heavily on retirement accounts during life, you may be able to preserve more taxable assets for your children. Most inherited brokerage accounts will be given a “stepped-up” cost basis. A step-up in basis values an asset on the date of your death, not the original cost. Ignoring the investment merits and other factors, this means your heirs could technically liquidate the account shortly after your death and pay little to no tax.
The right approach for you and your family will always depend on your specific situation, goals, and the current tax laws. You’ll also want to consider your marginal tax bracket versus what you expect your children’s will be to determine what’s likely to generate the greatest after-tax inheritance.
Balancing Tax Optimization With Retirement Planning Realities
Trying to perfectly optimize your retirement income plan is a difficult task. And with so many factors out of your control, like market conditions and expenses, complete optimization of when you withdraw funds might not be realistic.
Also consider your cash balances, timing of expenses and desire for routine income. Many retirees like the idea of living off their portfolio income, but dividends will vary as will living expenses. And as noted earlier, periodically resetting cost basis and controlled rebalancing is usually a feature, not a bug. It can also help decrease trading costs and turnover.
Since everyone’s circumstances and goals are different, work with your financial advisor and tax advisor to determine the best approach for your unique situation.