Retirement Planning


Paying Taxes Wisely: A Fresh Look at Tax-Efficient Withdrawal Strategies

December 7, 2018
Investors with tax-diversified portfolios can better sustain their retirement lifestyle by implementing a thoughtful withdrawal strategy.

Key Points

  • Tax diversification can improve investors’ ability to implement a tax-efficient withdrawal strategy in retirement.
  • A thoughtful strategy might allow a retiree to consistently stay within a low tax bracket or realize tax-free capital gains.
  • To reap tax benefits, it may be beneficial to take some money out of Roth accounts relatively early in retirement—a strategy counter to the “conventional wisdom.”
  • It’s important to plan ahead, before required minimum distributions take effect.

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’ll probably need to withdraw money from these accounts to supplement your Social Security income.

The conventional wisdom is to withdraw from taxable accounts first, followed by tax-deferred accounts, and, finally, Roth assets. This approach affords your tax-advantaged accounts more time to grow tax-deferred—but could also present you with more taxable income in some years than 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 IRA, 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 invested principal, which is tax-free). Long-term capital gains and qualified dividend income are generally taxed at lower rates than ordinary income.

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, and/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 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; and
  • Collects $29,000 in Social Security benefits.

Using the approach described above, they could completely avoid federal income taxes for 30 years and save $46,000 in taxes. This adds almost 2½ years to the life of their portfolio.

$750,000 portfolio; $65,000 annual spending in retirement
  Conventional wisdom Bracket-filling method
Account withdrawals (specific to this example) Taxable account (years 1–3); tax-deferred account (years 3–18); Roth account (years 18–30) Tax-deferred distributions $20,000–$23,000 each year; supplemented with taxable account (years 1–5) and Roth account (years 6–31)
Federal taxes paid over 30 years $46,000 $0
Longevity of portfolio with constant returns


29.2 years

31.6 years (8% improvement)

The chart is for illustrative purposes only and is not indicative of any specific investment. Additional assumptions: Amounts are in today’s dollars and rounded; investment returns (before taxes) of 3% above inflation; taxable account generates only qualified dividends and long-term capital gains; couple retires at age 65; federal taxes remain at 2018 levels; state taxes not considered.

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 less than $38,700 (for single filers) or $77,400 (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 recent 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 who has significant taxable investments. We’ll assume they:

  • Have $2 million across their investment accounts: 50% tax-deferred, 10% Roth, and 40% taxable;
  • Spend $120,000 per year; and
  • Collect $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.

$2 million portfolio; $120,000 annual spending in retirement

  Conventional wisdom Utilizing untaxed capital gains
Account withdrawals (specific to this example) Taxable account (years 1–25); tax-deferred (starting with RMDs in year 6, running out in year 34); Roth account (years 34 on) Before RMDs (years 1–5), use taxable account. Thereafter, supplement RMDs with $15,000–$20,000 per year from Roth account. Taxable account withdrawals are small until Roth account is depleted (year 22).
Federal taxes paid over 30 years $288,000 $230,000 (20% reduction)
Longevity of portfolio with constant returns 41.1 years 41.8 years (2% improvement)

The chart is for illustrative purposes only and is not indicative of any specific investment. Additional assumptions are the same as the first example.

As you approach retirement, keep in mind:

  • Taxes are complicated, so you will probably want to consult with a tax advisor or financial planner for help implementing these strategies.
  • Roth conversions are also an option, but our research indicates they are usually 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 70½, 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.

This material is provided for general and educational purposes only. This material does not provide fiduciary recommendations concerning investments or investment management. T. Rowe Price Investment Services, Inc., 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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