Retirement Planning

A Closer Look at Withdrawal Strategies

February 18, 2020
Investors can get more out of their retirement savings using a tax-savvy approach.

Key Points

  • The conventional wisdom of withdrawing from taxable accounts first isn't always the best strategy.
  • Limiting tax-deferred distributions to match tax deductions can help you stay in a lower tax bracket.
  • Some individuals pay no taxes on long-term capital gains, making withdrawals from taxable accounts a beneficial option.

One of the challenges we face in retirement is finding the most advantageous way to draw down savings while minimizing taxes. Many people have investments in a variety of accounts that have different tax characteristics. These can include Traditional IRAs or 401(k)s, Roth IRAs, and taxable brokerage accounts. In retirement, you probably will need to withdraw money from these accounts to supplement your Social Security income.

Conventional wisdom

“The conventional wisdom is to withdraw from taxable accounts first, followed by tax-deferred accounts, and, finally, Roth assets,” explains Roger Young, CFP®, a senior financial planner with T. Rowe Price. “This approach affords your tax-advantaged accounts more time to grow tax-deferred—but also could present you with more taxable income in some years than in others.” As your tax rate is dependent on your income, this could mean more taxes in those high-income years than you originally anticipated.

Federal income tax matters for retirees can be complicated. For example:

  • Withdrawals (distributions) from Traditional (pretax) IRAs or 401(k) accounts are fully taxed as ordinary income.
  • Qualified distributions from a Roth account are tax-free.*
  • For taxable accounts, interest received is ordinary income. However, if you sell investments, you only pay taxes on the gains (i.e., not on the invested principal, which is tax-free). Long-term capital gains and qualified dividend income generally are taxed at lower rates than ordinary income.

A thoughtful approach

Everyone has different financial goals in retirement, but if you’re concerned about outliving your assets, you might focus on extending the life of your portfolio or increasing what you can spend in retirement. Here are two ways you can use tax savings to help achieve these goals:

1. Take full advantage of income subject to very low, or even zero, tax rates.

People with relatively modest incomes may think it's best to follow the conventional model. After all, you may pay little or no taxes at first. However, once the taxable accounts are exhausted, you may end up paying a higher tax rate because you are generating more taxable income from tax-deferred account withdrawals.

Instead, consider using your low tax bracket strategically by consistently “filling up” that bracket with ordinary income from tax-deferred account distributions, such as your Traditional IRA. If you need more than these withdrawals to support your lifestyle, you can sell taxable account investments, then take money from Roth accounts. This idea isn’t new, but following the Tax Cuts and Jobs Act of 2017, more people may be able to limit their incomes to match their deductions—thus paying zero taxes—or stay within a low bracket.

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 the approach described above, they could completely avoid federal income taxes and save $38,000. This strategy adds two years to the life of their portfolio. (See “Filling Up Your Tax Bracket.”)

2. Make the most of untaxed capital gains.

Did you know that some people don’t have to pay taxes on capital gains? If your taxable income is $40,000 or less (for single filers) or $80,000 or less (for married couples filing jointly), long-term capital gains and qualified dividends aren’t taxed. This is another area where people may benefit from the 2018 increase in the standard deduction.

We’ve found that those who have a lot 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 was to tap in to the taxable account before taking required minimum distributions (RMDs), then a combination of taxable investments and Roth distributions along with the RMDs. By doing so, the couple can avoid capital gains taxes until the Roth account runs out. (See “Targeting Capital Gains First.”)

Implement your strategy

As you approach retirement, keep in mind that taxes are complicated, so you probably will want to consult with a tax advisor for help determining a withdrawal strategy. Roth conversions also are an option, but our research indicates that they usually are better suited for people focused on leaving an estate. Tax diversification—having assets in multiple types of accounts—can improve your flexibility in retirement. In both examples above, having some Roth assets is key to implementing the strategy. 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.

*Generally, distributions are tax-free once you reach age 59.5 and have held the Roth account for at least five years.

This material has been prepared by T. Rowe Price for general and educational purposes only. This material does not provide fiduciary recommendations concerning investments, nor is it intended to serve as the primary basis for investment decision-making. T. Rowe Price, its affiliates, and its associates do not provide legal or tax advice. 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 professional tax advisor regarding any legal or tax issues raised in this material.

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Next Steps:

  • For more detailed information, see our full report about various withdrawal strategies.