A Tax-Savvy Approach to Help Make the Most of Your Retirement Income

You will likely need to withdraw money from savings to supplement what you 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 your 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.”

The following strategies can help minimize overall tax liability from your retirement withdrawals:

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 or take money from your Roth accounts.

As an example, assume a married couple:

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 nearly 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.”)

If your 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:

The best strategy we found for this couple was to tap in to 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 our withdrawal strategies report (pdf).

As you approach retirement, keep in mind that taxes are complicated, so you will likely want to consult with a retirement specialist or tax professional for help in customizing a withdrawal 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.