Retirement Withdrawal Strategy:  Which Accounts First?  

Your withdrawal strategy in retirement shouldn’t just focus on maximizing your income. It should maximize the amount of income that ends up in your pocket. This can be tricky when considering many people have a combination of pre-tax, Roth, and after-tax accounts.  Do you withdraw everything from the Roth accounts first, and have no taxable income? Or, does it make sense to withdraw money from the after-tax accounts first, and let your pre-tax and Roth accounts grow? Or, maybe you just withdraw a combination of all of them?  Yeah, retirement planning is confusing. This article addresses the order in which you should withdraw your retirement accounts.

First, let’s start with from which accounts should you withdraw from first.  The general rule is that you withdraw the funds in this order:

  1. After-tax assets (savings, money market, and brokerage accounts)
  2. Tax-deferred assets (Traditional IRA and per-tax 401(k)/403(b))
  3. Tax-free assets (Roth IRA and Roth 401(k/403(b))

Overall, the reasoning is pretty simple.  Withdraw the least tax-efficient accounts first and the most tax-efficient accounts last.  After-tax assets, such as savings accounts and checking accounts, are probably earning very little and you have to pay taxes each year on any interest.  If you own an after-tax brokerage account, you have to pay taxes each year on the gains. It makes sense to withdraw these first and hold off on touching Roth accounts which are growing tax-free for you.  Not only will your Roth accounts grow tax-free for you, it can also be passed on to your kids/heirs tax-free as well. Roth accounts are really the best of the best, and the longer you can allow them to grow tax-free the better.  Given your situation though, the withdrawal order can be very complicated and entails a lot of tax planning.

Let me give you an example.  You retire and have significant after-tax assets (i.e. checking, savings, and brokerage accounts) as well as pre-tax assets.  You have no other income besides investment withdrawals and have plenty of after-tax money. In this example, you wouldn’t even need to touch the pre-tax assets for a few years.  Given the order of distributions that we discussed earlier, the distribution order would be to first withdraw the savings accounts. Then you would withdraw the pre-tax assets once you run out in a few years.  Woohoo, you don’t have to pay any taxes this year! This sounds great, but the objective is not to minimize taxes this year, it is to minimize taxes in retirement. You have better options than to have $0 in taxes for the next few years and then shoot up to a very high tax bracket when your pre-tax distributions start.  

Making use of your deductions and exemptions in retirement are very important.  A married couple in 2019 could have at least $24,000 in income and pay no-taxes. This is because the current standard deduction is $24,400 in 2019 for a married couple filing a joint tax return. Current tax rules also state that if you are in the 10% or 12% tax bracket, long-term capital gains are taxed at 0%! For retirees that have multiple types of accounts (Pre-tax, after-tax, and Roth) the first few years of retirement offer an unbelievable opportunity to take advantage of the lower tax brackets that you may experience compared to when you were working.  Below are a few examples of situations in which you should be taking full advantage of these potential lower tax brackets in retirement:

  • You have significant unrealized capital gains:  If you have taxable accounts with significant unrealized capital gains, this may be the best time to realize those gains.  As I mentioned before, if you are currently in the 10% or 12% tax bracket, long-term capital gains are taxed at 0%. Realize your capital gains, stay within the 12% tax bracket and live off of those proceeds and you will have very little or no tax burden.
  • If you are sitting on a significant pile of cash and pre-tax assets:  If the amount of cash or after-tax money that you have is more than 10% of your overall retirement savings, I would consider this to be fairly significant.   If this is the case I would typically suggest starting Roth conversions once you are retired. The reason that having cash on hand is important, is because you need the cash to be able to pay the tax burden of the Roth conversion.  When you do a Roth conversion the amount that you convert is taxable in the year in which the conversion takes place. The key to a Roth conversion is working with an experienced tax planner or financial advisor so that you don’t convert too much, kicking you into higher tax rates.  
  • If you have Roth accounts:  Typically, if you have Roth IRA money you will also have pre-tax funds as well.  If that is the case, don’t touch the Roth money! I know it is tempting to start withdrawing from the tax-free Roth accounts right away but the longer you avoid doing that, the better you will be.  My two rules with Roth money is 1) invest more aggressively (remember you aren’t touching it for a long time) 2) don’t touch it until you have run out of your pre-tax assets. The reason behind this is that the Roth money grows tax-free and it is not subject to Required Minimum Distributions (RMDs).  These are huge benefits compared to a pre-tax account.
  • Significant pre-tax assets and very little non-taxable money:  If your sole type of retirement savings is from pre-tax assets you may feel like you have no distribution planning options.  You probably don’t want to do Roth IRA conversions because then you are just withdrawing funds from the IRA to pay the taxes on the conversion which is not ideal  Your only option is to draw the funds from the pre-tax accounts and pay the taxes when you do withdraw the funds. One options that you do have in this scenario is wait to draw social security and live off of your pre-tax assets in the early years of retirement.  This allows you to draw down your pre-tax assets which will limit the amount of Required Minimum Distributions (RMDs) that you will incur at 70 ½. Also, this allows you to maximize your social security benefit and have more stable income later in your life.

Creating and sticking with a distribution strategy is maybe the most important part of a comprehensive retirement strategy. Yes, the rule of thumb states that you should  be taking out the least tax-efficient assets first (brokerage, savings) and the most tax-efficient last (Roth accounts). For certain circumstances it can be quite a bit more complicated, and you should have a solid plan here to maximize your take home pay and keep taxes low.  

Disclaimer:  I’m a financial advisor, but probably not your advisor and don’t know your complete financial picture.  Therefore, please use this as education only and I strongly suggest talking with your financial advisor or tax preparer before implementing any of the above strategies.  

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