Tax-Efficient Retirement Withdrawal Strategies

Five principles for tax-efficient withdrawals, three withdrawal strategies, and four factors to help you choose the best strategy.

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by Michael Sharpnack

When it’s time to retire and start living off investment income, you not only need to know how much income you can get, but also what withdrawal strategy to use.

Maybe you have an IRA, a Roth IRA, and a taxable account. Which account do you start with? How much do you take from each account?

Which strategy will save you the most taxes in retirement?

We’ll cover withdrawal strategies in three parts:

1. Five principles for tax-efficient withdrawals
2. Three withdrawal strategies
3. Four factors to help choose a withdrawal strategy

Five Principles for Tax-Efficient Withdrawals

While there are many different approaches to withdrawal strategies in retirement, a handful of principles help guide these strategies.

Not every principle applies in every situation, but some of the most important tax-efficient principles to keep in mind are:

1. Minimize required minimum distributions (RMDs)
2. Defer Roths
3. Be careful of Social Security and Medicare thresholds
4. Consider charitable withdrawals from IRAs (QCDs)
5. Diversify your tax situation

1. Minimize Required Minimum Distributions (RMDs)

With pre-tax retirement plans—such as IRAs and 401(k)s—you have never paid taxes on the money in the account.

You only pay taxes when you withdraw money from these accounts.

Well, the government doesn’t want you to hang on to the money and defer taxes forever. So they instituted a required minimum distribution (RMD), which is a specific amount of money the government requires you to take out of your account each year after age 72.

You must take the money out, and you must pay taxes on it.

You don’t have to spend the money. You can reinvest it, but you still have to pay the taxes.

You have to start taking RMDs each year after age 72 unless you turned 70 1/2 before January 1, 2020—in that case you are already subject to RMDs.

The amount you are forced to withdraw increases each year, and can eventually exceed how much you need to live on, causing you to pay much more in taxes over your retirement than you need to.

RMDs start at about 3.6% of your account value, and move up to over 5% in your 80s and over 8% in your 90s.

The higher percentages in later years can create unnecessary taxes. If you are 80 and you only need 3% of the account value to live on—but you’re required to take 5.3%—that’s an extra 2.3% of the account value you must withdraw and pay taxes on. On a $1,000,000 portfolio, that’s an extra $23,000 included in taxable income, which adds up over time.

Still, that may not sound like much, so here’s a visual of what RMDs might look like for a 73-year-old, who has $1 million account invested in a standard 60/40 asset mix, retiring in 2021:

                                                                                                    RMDs on $1 million

And if you’re still not convinced, here’s what taxes look like over that time when you add in an average Social Security benefit:

Total estimated taxes over this retirement are $480,000.

You read that right. $480,000 of your retirement savings going to the government. That doesn’t even count increases in tax bracket thresholds, Medicare premiums, or capital gains thresholds.

RMDs can quickly become tax inefficient if you don’t plan carefully for them.

We want to minimize RMDs as much as possible in order to decrease your total retirement tax burden.

2. Defer Roths

Roth IRAs grow tax free in retirement. And—as long as you follow the rules—withdrawals from Roths are tax free.

So the longer you are able to hold off on withdrawing money from Roth accounts, the more you’re able to take advantage of the tax-free growth. If a Roth has $100,000 in it today, you could just withdraw that amount tax free. But if you let it grow for another 20 years at say, 5%, then you would have $265,329 to withdraw tax free.

This works together with minimizing RMDs because deferring Roths forces you to withdraw more income from another account, such as a traditional IRA, which lowers the IRA account balance and thus lowers the future RMDs.

Roths also pass to your heirs tax free, while traditional IRAs can create a big tax burden for heirs.

In most situations, deferring Roths as long as possible is more tax-efficient than spending them early.

3. Be Careful of Social Security and Medicare Thresholds

More income means more of your Social Security benefits are subject to taxes.

Additional income also increases Medicare premiums, called an IRMAA (income-related monthly adjustment amount).

These thresholds can create a situation called a tax torpedo, where the additional income increases not only your federal income taxes, but also your Social Security taxes and Medicare premiums.

For example, say you are retired and have a taxable income of $42,000. Included in that income are IRA withdrawals of $38,000 and Social Security benefits of $25,000.

You want to take a trip that will cost $1,000. How much in taxes will you owe if you withdraw an extra $1,000 from your IRA?

Well, taxable income of $42,000 is in the 22% tax bracket, so 22% of $1,000 is $220. Therefore, you should pay an additional $220 in taxes, right?

Wrong.

You will owe an additional $407 in taxes—a 40.7% tax rate on that income.

Because of the Social Security thresholds, every dollar that you take out in additional income—up to a point—increases the amount of Social Security benefits subject to taxes, meaning an additional $850 of income from Social Security is added to your taxable income. Instead of increasing your taxable income by $1,000, the IRA withdrawal increases taxable income by $1,850.

Medicare also has its own thresholds. 

The income number they use for the thresholds is from two years prior, so in 2021 it’s based on the income you made in 2019. Even if you retire and are tax-efficient with your income—if your income was over the thresholds while you were working—you may be hit with unexpectedly high Medicare premiums for the first two years.

The first two thresholds are the most important to be aware of (2021 premiums based on income from 2019):

Your Medicare premium is $148.50 per month in 2021 for income in 2019 that is below the first threshold of $176,000. But above that threshold it’s $207—about $50 more per month to the government. Then, it jumps quickly at $222,000 of income to $297 per month.

To be tax efficient, you must maneuver both the Social Security and Medicare thresholds carefully.

4. Consider Charitable Withdrawals From IRAs (QCDs)

Qualified charitable distributions (QCDs) allow you to pay your RMDs straight to a charity, tax free.

This is the most tax-efficient you can be. When you contribute money to an IRA, you receive a tax deduction, so you don’t pay any taxes on amounts deposited into your IRA. Then, in retirement, the money goes out of the IRA and to the charity without any tax consequences. Tax free in, tax free out.

But make sure to follow the QCD rules carefully because your payment won’t be tax free if you don’t.

If you already donate money to charity, QCDs are an obvious choice. Even if you don’t currently donate, the tax efficiency here should cause you to consider it.

You don’t have to itemize deductions to take advantage of a QCD. In fact, the amount that you give to the charity through the QCD isn’t considered as income on your taxes.

QCDs simplify the process of charitable giving and tax filing.

5. Diversify Your Tax Situation

We talk a lot about diversifying your investment portfolio, but you can also diversify your tax situation.

You diversify your tax situation by spreading your assets between multiple types of tax treatment. For example, keeping some assets in Traditional IRAs, some in Roth accounts, and some in taxable accounts gives you three different types of tax treatment on your retirement money.

The benefits of tax diversification include flexibility and some protection against policy changes.

Having assets under different tax treatments gives you the flexibility to control your taxable income in any given year. For example, if you receive extra income in a year—maybe from an inheritance, contract work, or the sale of an asset—then you may want to keep taxable income down by drawing from Roth or non-qualified accounts that year.

Conversely, in a year where your income is lower, you may want to take advantage of the low tax bracket to convert a traditional IRA to a Roth, or sell highly appreciated assets under a lower capital gains bracket.

Tax diversification also protects some from potential changes in tax policy. For example, right now, you can withdraw Roth assets tax free. But in the future, the government could change that either by taxing them directly, or by adding a federal sales tax.

Keeping money in a traditional IRA—where you haven’t paid any taxes on the money yet—can help offset those potential changes. But if federal income taxes increase in the future, Roth assets become even more valuable.

What Order Should You Withdraw From Retirement Accounts?

Once you understand the basic tax treatment of retirement accounts and the fundamentals for tax-efficient strategies, you can start to build a specific withdrawal plan.

First, we’ll talk about traditional withdrawal strategies, and then we’ll discuss some of the more advanced strategies that have come out of the research from the past 15 years.

The Traditional Withdrawal Strategy

The conventional wisdom on withdrawal strategy is to deplete each type of account before moving onto the next type of account.

The conventional strategy works like this:

1. Completely spend down taxable non-qualified accounts
2. Completely spend down pre-tax accounts (IRAs, 401(k)s, etc.)
3. Lastly, use Roth accounts

Using taxable accounts before IRAs and other pre-tax accounts is standard because of the tax-free growth on pre-tax accounts. While withdrawals from taxable accounts receive better tax treatment than pre-tax accounts, the taxes created each year from taxable accounts slow down their growth. Because IRAs and Roths defer taxes, they grow more efficiently.

Visually, the goal is for the account values to look something like this:

You can see this person starts out with a large IRA, a mid-sized taxable account, and a mid-sized Roth. The taxable account is spent down first, followed by the IRA, until nothing is left except the Roth account.

In practice, however, it doesn’t always work out like that.

Problems With the Traditional Approach to Retirement Withdrawals

First, the traditional approach breaks a couple of the rules of tax efficiency.

This strategy doesn’t minimize RMDs because IRA assets are left untouched in the beginning to grow tax free. While this does take advantage of tax-deferred growth, it also leaves you with a big pre-tax account later in retirement—right when RMDs are highest. A large IRA combined with high RMDs creates high taxes.

Social Security taxation isn’t considered under the conventional strategy either because the years where only IRA assets are drawn from can cause more Social Security benefits to be subject to taxes, as well as causing Medicare premiums to go up.

This approach doesn’t diversify your tax situation either. At the end, only one account type is left: Roth. This doesn’t leave you flexibility for years with fluctuating income, and it makes you vulnerable to policy changes that could adversely affect Roths.

Finally, in practice, many times IRA assets simply are not spent down. Instead, they may become bigger than what you started with, compounding the problem of high RMDs in the future.

It often ends up looking like this:

You can see taxable assets are spent down initially while the IRA grows, and then in the early 80s, RMDs are big enough to hold the IRA steady, while the taxable account was never spent down and starts to grow again.

Taxes look something like this:

Minimal taxes early on, but the continued growth of the IRA compounds the RMDs problem, and makes for high taxes in the future.

Some people don’t think they will live that long, so they’re not concerned with high taxes in the future, but life expectancies are much longer than many people realize, and the average retirement lasts about 25 years.

High taxes in later years puts increased stress on your portfolio—potentially right when you may need it most due to health expenses.

Modern Approaches to Tax-Efficient Withdrawals

Research over the past 15 years has shown that—in many cases—it’s more tax efficient to spend down pre-tax accounts first, such as IRAs, to reduce future taxes.

The modern approach has two main strategies: the proportional strategy and the Roth conversion strategy.

The goal of each of these approaches is to lower the overall tax burden throughout retirement by keeping IRAs and other pre-tax accounts from growing too big, and thus keeping future RMDs down.

At this point, you might be tempted to think you should simply draw from IRAs first to spend them down entirely before moving to the next type of account.

The problem with spending only IRA assets first, however, is that—since IRAs are fully taxable—it still pushes your tax brackets higher early on. These taxes can drive up Social Security taxation, Medicare premiums, and capital gains taxes. Additionally, the taxable account is left to grow untouched, but since it grows inefficiently because it’s taxed each year, total portfolio assets are usually less.

One solution to this problem is to split withdrawals between IRAs and taxable accounts. This is called the proportional withdrawal strategy.

The proportional approach is balanced and seeks to draw some money from IRAs early on so the account is not as big in later years, but it also draws some from the taxable account so tax brackets are not too high early on and to still take advantage of some of the tax-deferred growth of the IRA.

Account values with a proportional approach look like this:

IRA assets remain lower throughout the strategy, while taxable assets are higher than they are in the traditional approach.

Here’s the tax outcome:

So it’s more balanced throughout retirement. This approach pays more taxes early on, but less later on.

This strategy, in general, ends up with less total taxes throughout retirement, and higher portfolio values. It defers Roths, diversifies the tax situation well, and it spreads taxes more evenly across retirement, which helps avoid tax torpedoes.

Still, there’s another strategy that is often even more effective.

Roth Conversion Withdrawal Strategy

In many cases, the Roth conversion approach is the most tax-efficient withdrawal strategy.

The idea behind this strategy is to convert some pre-tax, IRA assets to Roth in the early years. This takes advantage of lower tax brackets early in retirement, before RMDs—or at least before RMDs are too high—but still benefits from the tax deferred growth of IRAs.

Steps to the Roth conversion strategy:

1. Convert a portion of your traditional IRAs to Roth IRAs in the first few years of retirement.
2. Live off income from taxable accounts during the Roth conversion years.
3. Pay Roth conversion taxes from taxable accounts.
4. Use a proportional approach later on in retirement to maintain tax diversification.

When you convert assets from a traditional IRA to a Roth IRA, you pay taxes on the amount converted right away. But once the assets are in the Roth, you don’t pay taxes on them again.

Pay taxes now to avoid paying taxes later.

But you must be careful—if you convert too much, you will drive your tax bracket too high and lose efficiency. You also want to avoid converting too much so you don’t end up with everything in Roth. Roth conversions are a balancing act.

It helps to visualize this process with the stacked tax brackets.

Let’s say you are married filing jointly and have an income of $60,000:

Notice how much more room you have before reaching the 22% bracket—$46,150 to be exact.

The next $46,150 of income will be taxed at 12%, and any income above that amount will be taxed at 22%. This leaves an opportunity to take advantage of the 12% bracket with a Roth conversion, and not pay any more tax—proportionately—than we would have otherwise.

Let’s say we decide to convert $40,000, which takes us close to the 22% tax bracket but leaves a little wiggle room. It also makes the numbers simple.

It looks like this:

The additional $40,000 in taxable income is all taxed at the 12% bracket.

Doing this in the early years before RMDs can save thousands in taxes over retirement while still maintaining the tax efficiency of tax-deferred growth because we’re preserving Roth assets.

Here’s what it looks like:

The IRA is spent down significantly early on due to the conversions, the taxable account is drawn down with it, and the Roth grows bigger. Then, later on in retirement, the IRA is maintained while taking RMDs.

Here’s the tax picture:

This pays higher taxes for the first few years during Roth conversions, but then the taxes taper off because RMDs are the lowest in this strategy.

The taxable account is key to the Roth conversion strategy.

Live off the taxable account and pay the additional taxes generated from the conversion with it. This helps keep your tax bracket lower, and it allows you to convert more assets to Roth.

Without the taxable account, you would have to pay taxes out of the Roth conversion, decreasing efficiency. For example, if you convert $100,000 and pay $10,000 in taxes, you would only be able to move $90,000 into the Roth, unless you pay $10,000 in taxes out of pocket.

But who wants to do that?

Instead, convert the full $100,000 into the Roth and pay the $10,000 from the taxable account, effectively converting some of the taxable account into Roth.

When done right, and in the right circumstances, the Roth conversion strategy saves taxes in retirement, minimizes RMDs, and keeps the diversification across accounts. The lower taxes in the future also help to keep Medicare premiums and Social Security taxes down.

The best strategy for you depends on your unique situation, and you should talk to a qualified financial planner before making any major decisions.

Four Factors to Help Choose a Withdrawal Strategy

Here are the most important factors to take into account when deciding on a withdrawal strategy for you:

1. Available taxable assets
2. Size of pre-tax accounts
3. Other income sources
4. Legacy goals

Available Taxable Assets

Taxable accounts are the most flexible type of account but the least efficient. The amount you have in them helps determine which strategy you should choose.

Without any taxable assets, your options for choosing a strategy are limited. The proportional approach doesn’t work, and while you can still use a Roth conversion strategy, the lack of a taxable account makes converting to Roth less efficient.

Larger taxable accounts make the proportional and Roth conversion strategies more likely to work for you.

It’s a good tip to save additional income into taxable accounts while you’re working for this reason. However, you should consider maxing pre-tax accounts first, before contributing additional income into taxable accounts, because the tax deductions and tax-deferred growth of pre-tax accounts usually outweigh the flexibility of a taxable account, particularly while working.

Size of Pre-Tax Accounts

Pre-tax accounts affect your withdrawal strategy the most because you pay the most taxes on them and they are subject to RMDs.

In general, the more money you have in IRAs, the more you should consider the Roth conversion strategy. But you have to weigh this against your expenses. Even with a large IRA, if your expenses are high, your expenses may force you to take enough money from the IRA that a Roth conversion wouldn’t be ideal because you’re in a higher tax bracket.

However, you still have to take all factors into account. Even with a large IRA, if you have a large taxable account to live off, then Roth conversions are usually a good idea.

Large IRAs with enough taxable assets very often mean Roth conversions are most efficient.

If you don’t have much money in pre-tax accounts, then focusing on the traditional approach may be best.

If you have a lot in Roth compared to everything else, then, first of all, congrats. You won’t be paying much in taxes in retirement. But that also means you’ll probably need to take an income from Roths earlier on. That’s okay, though, because you’re being as tax efficient as possible, as long as the Roth withdrawals can sustain your expenses through retirement.

Other Income Sources

When deciding a retirement withdrawal strategy, you must take all income sources into account.

Examples of other income sources:

• Social Security
• Pensions
• Annuities
• Rental income
• Work: part-time, contract work, businesses, hobbies
• Taxable inheritances
• Sales of appreciated assets

Roth conversions are most efficient when tax brackets are lower.

Additional income pushes tax brackets higher and makes the Roth conversion strategy less efficient. You have to weigh future RMDs versus your tax brackets now. If future RMDs will push your tax brackets higher than they are now, then converting some to Roth now makes sense. But if your tax situation looks to stay the same, then sticking with the traditional approach may be best.

You also have to consider one-time payments of income like inheritances, selling an appreciated asset, or working on a one-time project. You may avoid a Roth conversion in these years, but convert some to Roth in years when no additional income comes in.

Legacy Goals

Legacy goals refer to where you want to leave your money after you die.

The three main categories of legacy goals are:

1. Heirs: kids, grandkids, siblings, nephew/niece, etc.
2. Charity
3. Spend it all

Where you want to leave your money affects the withdrawal strategy you should use.

For example, Roths are the best inheritances for heirs to receive, but they are the least efficient to give to charity.

Heirs don’t pay any taxes when they inherit a Roth. Alternatively, IRAs are fully taxable and can create quite a tax burden for an heir to receive. For someone in their 30s, 40s, or 50s who is working and making a decent income, an inherited IRA could cause them to pay over 30% in taxes on the inheritance. They will still gladly accept it, but they would much rather receive a Roth tax free.

But when you leave money to charity, the charity doesn’t pay taxes on the gift—whether you leave them a Roth or a traditional IRA.

Leaving an IRA to charity is most efficient because you don’t pay any taxes on the money when you contribute to the IRA, and then the charity receives it tax free. A Roth is inefficient to leave to a charity because you pay tax on the contributions, and then the charity receives it tax free. So you pay taxes on money that doesn’t need to have any taxes paid on it.

If you are not concerned with where you leave your money, but instead you want to spend as much of it as you can, then you won’t be concerned about the tax efficiency of the money at the end of your life, and you’ll only be concerned about saving taxes throughout your life.

You also might consider adjusting your distribution amount when you hope to leave as little leftover as possible. But you need to balance that with the risk of running out of money.

Always consult a qualified financial professional before making any withdrawal strategy decisions.

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