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-Efficient Retirement Withdrawal Strategy 1

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)

Long-Term Capital Gains Tax Rate Single Married, filing jointly
0% $0 to $39,475 $0 to $78,950
15% $39,476 to $510,300 $78,951 to $612,350
20% $510,301 or more $612,351 or more


Federal Income Tax Rates (2019)

Marginal Tax Rate Single Married, filing jointly
10% $0 to $9,700 $0 to $19,400
12% $9,701 to $39,475 $19,401 to $78,950
22% $39,476 to $84,200 $78,951 to $168,400
24% $84,201 to $160,725 $168,401 to $321,450
32% $160,726 to $204,100 $321,451 to $408,200
35% $204,101 to $510,300 $408,201 to $612,350
37% $510,301 or more $612,351 or more


Social Security Benefits Subject to Tax (2019)

Percentage Subject to Tax Single Married, filing jointly
0% $0 to $24,999 $0 to $31,999
50% $25,000 to $34,000 $32,000 to $44,000
80% $34,001 or more $44,001to $39,375


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 and Saving Money

First, you must account for all other incomes that you’re getting. These incomes include Social Security benefits, pension, 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.

Also, 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.

Tax-Efficient Retirement Withdrawal Strategy 2

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.
  2. Use your non-retirement savings income sources.
  3. Use dividend and interest 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. TIP: Do not automatically reinvest dividends and interest in your taxable accounts.
  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.

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 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 sooner. This reduces the chance of your RMD pushing you above your tax sweet spot when you turn 70½.

3. 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.

4. 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.

5. 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.

6. Estate Planning

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.

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.

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