Maximize your savings: Tax-efficient retirement withdrawal strategies

Depending on your retirement plan, a lot can change as you transition from building savings during your work years to withdrawing your savings during retirement. At least one thing, however, will stay the same: You will have plenty of financial decisions to make, and your choices will affect your ability to make the most of your savings.

In retirement, one of the biggest questions is, which of your retirement accounts will you draw from when you need to fund expenses? Your answer can impact your tax liability, especially if your net worth is high. Following a tax-efficient withdrawal strategy can help you preserve your wealth and meet your financial goals.

Your retirement investment assets are likely spread across several different accounts. When you make a withdrawal, whether and how it will be taxed depends on the account type: taxable, tax-deferred or tax-exempt. Keep in mind that withdrawals made from tax-deferred retirement accounts before you turn 59 ½ years old, with rare exceptions, will be subject to an additional 10% early withdrawal penalty.

Also know that the sale of assets in a taxable account, such as a typical brokerage account, is subject to long-term capital gains tax (assuming you’ve held the assets for more than a year) of 0%, 15% or 20% depending on your income tax bracket. Because you originally invested after-tax dollars, you will only pay taxes on any gains realized.

Distributions from a tax-deferred account, such as a traditional IRA or 401(k), are treated as ordinary income, with current tax rates ranging from 10% to 37%. Because contributions were tax-deductible, the entire withdrawal amount is taxable.

Qualified distributions from a tax-exempt account, such as a Roth IRA or Roth 401(k), are entirely tax-free in retirement. You also can withdraw your contributions tax-free before retirement; however, any earnings you withdraw will be taxed as income. The early withdrawal of earnings from a Roth IRA may also be subject to a 10% penalty.

Because each of these accounts is taxed so differently, it takes a smart withdrawal strategy to minimize tax liability and help preserve wealth. Conventional wisdom suggests that you should withdraw from taxable accounts first, then from tax-deferred accounts and then from tax-exempt accounts. The goal of this approach is to get the most out of your tax-advantaged retirement accounts by leaving them exposed to potential growth for as long as you can.

There is a certain logic to this approach, but there are also some complications. One is required minimum distributions (RMDs): Beginning at age 73, you must take distributions from your tax-deferred retirement accounts, such as traditional IRAs and 401(k)s, each year. And those distributions will typically be taxed as ordinary income. Another complication is progressive income tax, in which your marginal tax rate is set according to your total taxable income for the year. This means that there is a chance your RMDs alone could bump you into a higher tax bracket.

Taking these complications into account helps you arrive at a potentially more tax-efficient withdrawal strategy. One example is the “spending waterfall”: If you need to turn to your retirement accounts to fund your expenses, you will ideally first spend any RMDs from your tax-deferred accounts, then draw from your taxable accounts. Then, if you are in a lower income tax bracket than usual this year, you could take additional distributions from tax-deferred IRAs and 401(k)s, increasing their after-tax value and reducing the size of future RMDs. Finally, you could sell assets in your taxable accounts.

To further increase the tax efficiency of your retirement withdrawals, we suggest working with a financial advisor, in conjunction with a tax professional, to devise a strategy tailored to your portfolio and overall retirement goals.

The strategic withdrawal approaches mentioned above assume that your retirement assets are spread across accounts with different tax treatments. If you’re still at the saving phase for retirement, consider making greater contributions to Roth accounts in years where you have lower taxable income and then contributing more to tax-deferred accounts in years where you have higher taxable income.

If you’re already retired and your investment assets are heavily weighted toward tax-deferred accounts, you can use these potentially lower-than-normal income years to convert additional tax-deferred assets into Roth accounts. The dollars converted would be taxable, but you would increase the balance in the accounts that offer tax-free growth and distribution. You’d also reduce the balance in your tax-deferred accounts, which may lower the size of your required minimum distributions, giving you more flexibility in managing your tax burden in retirement.