How to make tax-efficient withdrawals in retirement

Thoughtful planning around retirement withdrawals can help you retain more of your money, allowing for greater comfort and freedom in retirement.

Table of contents:

• Why tax efficiency matters in retirement
• How brokerage, traditional, and Roth retirement accounts are taxed
  
• Choosing your withdrawal strategy: 3 options
• Advanced tactics for tax-optimized withdrawals
• Checklist: Creating your withdrawal plan

Why tax efficiency matters in retirement

Taxes play a critical role in determining how long your retirement savings will last. Without a tax-aware strategy, your retirement income may not last as long as it could.

Here’s what you’ll need to consider for retirement:

• Withdrawals from traditional retirement accounts can inadvertently push you into higher income brackets
• A higher tax bracket can potentially trigger steeper taxes on Social Security benefits and boost your Medicare premiums. 
• A tax-efficient plan helps delay unnecessary taxation, potentially increasing your net income.

The big takeaway: Any unnecessary taxes on your retirement withdrawals can decrease your retirement income and shorten the lifespan of your savings.

How brokerage, traditional, and Roth retirement accounts are taxed

Most retirees hold assets across three types of accounts, each with its own tax implications. Knowing which bucket to tap—and when—is essential to optimizing after-tax income.

• Taxable accounts: brokerage and savings accounts
• Tax-deferred accounts: traditional 401(k) and traditional IRA accounts
• Tax-free accounts: Roth 401(k) and Roth IRA accounts

The table below outlines the differences in how the three account types impact taxes from the time of contribution to the time of withdrawal. Choosing the right mix of accounts for timing withdrawals can help shape a smoother retirement income flow and potentially minimize tax consequences.

Choosing your withdrawal strategy: 3 options

There are three primary retirement withdrawal strategies used to balance taxes and preserve assets: Sequential “waterfall,” Proportional, and Personalized tax-bracket-aware. These are not one-size-fits-all approaches—the right strategy depends on your finances, account types, and income goals, and can change year to year. A financial planner can help you decide what’s best for you.

Option 1: Sequential “waterfall” strategy

The sequential “waterfall” strategy is a simple, orderly method where you take withdrawals from one account type at a time, in this order:

1. Taxable accounts
2. Tax-deferred accounts
3. Tax-free accounts

This approach maximizes the growth potential of tax-advantaged funds in Roth accounts but may become rigid once required distributions begin. 

Additionally, retirees may end up paying more in taxes in the middle of retirement during the period when they are withdrawing from tax-deferred accounts. Remember, withdrawals from traditional 401(k)s and IRAs are taxed as ordinary income. Because of this, a proportional withdrawal strategy may be a good fit for retirees with multiple account types.

Option 2: Proportional withdrawal strategy

A proportional withdrawal strategy is a systematic way to take money from all of your retirement accounts each year in proportion to their current balances. 

Instead of draining one type of account before moving to the next, you withdraw from each account type—taxable, tax-deferred, and tax-free—based on its share of your overall portfolio. In some cases, retirees may want to draw down taxable and traditional accounts proportionally, and then withdraw from Roth accounts.

A proportional withdrawal strategy may provide the following benefits:

• Smooths taxable income: By smoothing out your taxable income throughout retirement, you can potentially pay less tax on your Social Security benefits and lower your Medicare premiums.
• Controls RMD impact: Potentially reduces large required minimum distributions (RMDs) later in retirement, which can push you into a higher tax bracket.
• Enhances longevity: If implemented properly, a proportional withdrawal strategy can make your portfolio last longer into retirement.
  

Here’s an example, using a $1,000,000 portfolio (in reality, more details such as Social Security payments would need to be considered). 

The retiree would repeat this proportional withdrawal strategy every year, recalculating the ratios as balances change over time.

Option 3: Personalized tax-bracket-aware strategy

A personalized, tax-bracket-aware withdrawal strategy is a custom method designed to keep your taxable income within a target tax bracket each year. The goal is to make your total tax bill in retirement more predictable and potentially lower over time. 

Here's how it works at a high level:

1. Fill your target bracket—don’t exceed it: Tap tax-deferred accounts like traditional IRAs or 401(k)s just enough to reach the top of your target tax bracket (e.g., 12% or 22%), then turn to taxable brokerage or Roth accounts for any additional income needed.
2. Revisit your strategy every year: As income from sources like Social Security or RMDs changes, adjust withdrawals to stay within your target bracket.
3. Take advantage of low-income years: After retiring but before major income sources begin, you're often in your lowest bracket. This may be an ideal time for Roth conversions or realizing capital gains at preferential rates.

This strategy requires ongoing monitoring, but it may offer strong long-term tax benefits, depending on your specific situation. A tax or financial professional can help tailor it to your needs.

Pros and cons of each withdrawal strategy

Advanced tactics for tax-optimized withdrawals 

Depending on your situation, these advanced tactics may help you reduce your tax bill in retirement.

• Required minimum distributions (RMD) planning: To start, estimate your future RMD amounts based on account balances and IRS life expectancy tables to avoid unexpected tax spikes. Consider spreading withdrawals across multiple years to avoid bumping into higher tax brackets. As you plan withdrawals, it’s important to coordinate them with Social Security and Medicare to minimize taxes on benefits and avoid surcharges on Medicare premiums. 
• Roth conversions: Roth conversions let you move money from a tax-deferred account like a traditional 401(k) to a Roth 401(k), paying taxes on the converted amount now to help reduce future RMDs and gain access to tax-free withdrawals later.
• Qualified Charitable Distributions (QCDs): After age 70½, you can donate up to $100,000 per year from your IRA to a qualified charity. These Qualified Charitable Distributions (QCDs) count toward RMDs but aren’t taxable, helping reduce your overall retirement tax bill.
• Capital gains and tax-loss harvesting: By selling appreciated assets during low-income years, you can potentially pay 0% long-term capital gains rates. Conversely, with tax-loss harvesting, you can sell investments for a loss in higher-income years to offset taxable gains or ordinary income.

The more retirement accounts and sources of income that you have, the more complexity is involved. As previously mentioned, working with a tax professional or a financial advisor can help you navigate tax situations that may require a deep understanding of retirement planning.

Checklist: Creating your withdrawal plan

Here’s a step-by-step checklist to help you build a withdrawal plan tailored to your situation:

• Estimate annual spending and taxable thresholds, including Social Security and RMD timing.
• Take stock of your account balances across taxable, deferred, and Roth accounts
• Choose a withdrawal strategy, working with a tax professional if needed:
  • Sequential “waterfall”
  • Proportional
  • Personalized tax-bracket-aware
• Plan capital gains and tax-loss harvesting, respectively, for low-income and high-income years
• Plan Roth conversions strategically during low-income years
• Schedule QCDs if giving to charity and you’re RMD-eligible
• Set up annual reviews to adjust for changing income, tax rules, or personal goals

Be intentional and plan ahead

Tax-efficient withdrawals aren’t just smart, they’re essential for sustaining retirement savings over decades. Whether you prefer a straightforward order, a balanced blend, or a highly adaptive tax-driven strategy, the key is to be intentional about when and how you access your funds. 

Remember, it can pay off to consult with a tax professional to learn what may work best for you, especially if you have a complex situation with multiple retirement accounts.