A Tax-Savvy Approach to Help Make the Most Out of Retirement Income
How investors can get more out of their retirement savings.
- Drawing retirement income from taxable accounts first isn’t always the best strategy.
- Choosing the amount of tax-deferred distributions your clients take can help them stay in a lower tax bracket.
- Withdrawals from taxable accounts can be particularly beneficial for individuals in the lowest tax brackets.
Your clients will likely need to withdraw money from savings to supplement what they receive from Social Security and any other sources of income in retirement. One challenge can be finding the most advantageous way to draw down these savings while minimizing taxes. Many people hold investments in a variety of accounts that have different tax characteristics. Having a variety of account types—Traditional and Roth versions of individual retirement accounts (IRAs) or 401(k)s, along with taxable brokerage accounts—creates tax diversification, which can provide greater flexibility to their withdrawal strategy.
“You can potentially get more out of your retirement savings by withdrawing money tax-efficiently,” explains Roger Young, CFP®, a thought leadership director with T. Rowe Price. “This is appealing for those concerned about outliving their funds or who want more money to spend in retirement.”
Two tax-efficient strategies
The following strategies can help minimize overall tax liability from retirement withdrawals:
1: Take full advantage of income subject to low tax rates.
Consider using a low tax bracket strategically by consistently “filling up” that bracket with ordinary income from tax-deferred account distributions, such as a Traditional IRA. If your clients need more than these withdrawals to support their lifestyle, they can sell taxable account investments or take money from their Roth accounts.
As an example, assume a married couple:
- Has $750,000 across their investment accounts: 60% tax-deferred, 30% Roth, and 10% taxable
- Spends $65,000 (after taxes) each year
- Collects $29,000 in Social Security benefits
Using this approach, the couple supplements Social Security income each year with approximately $23,000 to $25,000 from tax-deferred accounts and $11,000 to $13,000 from taxable or Roth assets. By fully offsetting ordinary income with the standard deduction,1 they completely avoid federal income taxes and save $35,000 throughout retirement. This strategy adds two years to the life of their portfolio compared with following the conventional wisdom of drawing on taxable accounts first, followed by tax-deferred accounts, and then tax-free accounts. (See “Retirement Income Strategies Make a Difference.”)
Retirement Income Strategies Make a Difference
By pursuing a bracket-filling income strategy instead of following conventional wisdom, the couple avoids federal income taxes and adds two years to the life of their portfolio compared with following the conventional wisdom of drawing on taxable accounts first.
Note: Amounts are approximate and do not depict the transition years when income sources change (or the final partial year). Primary income sources noted are those from investments, in addition to Social Security benefits.
*Nontaxable sources include return of principal from sale of investments in taxable accounts, Roth qualified distributions, and the untaxed portion of Social Security.
1 Reflects tax rates in effect during 2022.
2: Make the most of untaxed capital gains.
If taxable income is $41,675 or less (for single filers) or $83,350 or less (for married couples filing jointly), long-term capital gains and qualified dividends aren’t taxed.
We’ve found that those who have a healthy portion of assets in taxable accounts may be better served by taking advantage of untaxed capital gains than by taking tax-deferred distributions to fill up ordinary income brackets.
Let’s look at an example with a married couple that has significant taxable investments. We’ll assume the couple:
- Has $2 million across their investment accounts: 50% tax-deferred, 10% Roth, and 40% taxable
- Spends $120,000 per year
- Collects $45,000 from Social Security
The best strategy we found for this couple was to tap into their taxable account in the years prior to required minimum distributions (RMDs). Then they can combine sales of taxable investments, Roth distributions, and the tax-deferred account RMDs.
The Roth distribution amounts are carefully chosen (approximately $2,000 to $9,000 per year) to keep the couple’s income below the capital gains tax threshold. That saves them over $41,000 throughout retirement in taxes compared with the conventional approach. (For additional details, see troweprice.com/withdrawalstrategiesreport.)
Consider your strategy
Tax diversification can expand your options in retirement. In both strategies mentioned, the availability of Roth assets is necessary for implementation. RMDs can significantly reduce your flexibility to manage taxes after age 72, so you need to develop a plan well ahead of that milestone. “With a little planning and a variety of accounts in your portfolio, you can save on taxes and better sustain your retirement lifestyle,” says Young.
This material has been prepared for general and educational purposes only. This material does not provide recommendations concerning investments, investment strategies, or account types. It is not individualized to the needs of any specific investor and is not intended to suggest that any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or tax professional regarding any legal or tax issues raised in this material.
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