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Tax Planning

How to Save Taxes When Withdrawing from Your Retirement Income

A smart withdrawal strategy during retirement can help make your portfolio last longer, while easing potential tax burdens.

Articles by Nick Holeman, CFP®

By Nick Holeman, CFP®
Financial Planning Expert, Betterment  |  Published: September 20, 2016

The order in which you withdraw money from your investment accounts can impact how long your portfolio lasts in retirement.

In general, you should withdraw first from taxable accounts, then tax-deferred accounts, and lastly, tax-free accounts.

You should adjust this strategy if there are any income and tax bracket fluctuations throughout your retirement years.

When you retire, you can no longer count on a paycheck to fund your lifestyle. Though you may have some sources of fixed income, such as from Social Security or defined benefit pension plans, the income from these sources may not be enough to cover all of your regular expenses.

That leaves you relying on the money from your investment portfolio to maintain your expenses and lifestyle.

As a smart investor, you probably have an idea of how much money you can safely spend during each year of retirement.

But still, one important question remains: In which order should you withdraw from your accounts?

While the true answer to this question depends largely on your individual circumstances, your actions can have a huge impact on both your tax bill and the longevity of your portfolio.

Taxes will likely be one of your largest expenses in retirement (on par with healthcare), so a smart withdrawal strategy is crucial to your retirement success. Luckily, you have more control over your taxes in retirement than at any other point in your life. While there are common strategies to follow, other more advanced strategies could lead to substantial tax savings.

At Betterment, we’ve established some guidelines to not only build a smart retirement income plan, but also to try to save on taxes by establishing an order in which you should withdraw from your various investment accounts in retirement.

But first, let’s examine how your money is taxed when withdrawn in retirement.

How Withdrawals Are Taxed

Before creating your retirement income strategy, you must first understand how withdrawals from your various accounts are taxed. Here, we explain the tax consequences by taxable, tax-deferred, and tax-free accounts.

  • Taxable Accounts (individual, joint, and revocable trust): Investment income, such as dividends or interest income, is taxed in the year it is earned. So if you receive a dividend this year, you must pay taxes on it this year. Any withdrawals are subject to capital gains tax, but only on the growth of the investment.
  • Tax-Deferred Accounts (Individual Retirement Accounts, or IRAs), 401(k), 403(b), and TSP): Unlike taxable accounts, no taxes are due on investment income or growth until you make a withdrawal. When you do take money out, that full amount is subject to ordinary income tax.
  • Tax-Free Accounts (Roth IRA or Roth 401(k)): All investment income, growth, and withdrawals are tax-free.

Taxes on Withdrawals Vary By Account Type


As you can see, pulling money from each of these account types (taxable, tax-deferred, and tax-free) can have very different tax consequences.

A Withdrawal Strategy for Tax Efficiency

The general order for withdrawing money from your various accounts during retirement is as follows:

  1. First, pull money from your taxable accounts.
  2. Once those accounts are depleted, begin withdrawing money from tax-deferred accounts.
  3. Lastly, take money out of tax-free accounts.

The reason that this strategy is generally most tax-efficient is the power of tax deferral and the compound growth that it provides.

The longer you can shelter your tax-deferred and tax-free accounts, the better. That means more money stays in your accounts and can grow over time. Let’s look at how this works.

Example: Why You Should Withdraw From Taxable Accounts First

If you decide to withdraw money from your 401(k), every dollar will be taxed as ordinary income, which is the highest tax rate to which you are subjected.

In this hypothetical example, let’s say you need $1,000 and you are in the 25% marginal tax bracket. To end up with a net of $1,000, you would actually have to withdraw $1,333 because of the additional tax liability:

$1,333 (amount withdrawn) x 25% (marginal tax bracket) = $333 (taxes owed)

However, if instead you first pull money out from your taxable individual account, two things happen.

First, as long as the money has been invested for over one year, the tax rate is lower. Long-term capital gains taxes are generally 15%.1

Second, you don’t pay taxes on the full withdrawal, only on the growth. So if you bought the investment for $600, you only have to withdraw $1,071:

$1,071 (amount withdrawn) – $600 (your basis) = $400 (capital gain) x 15% = $71 (taxes owed)

A $1,333 withdrawal versus a $1,071 withdrawal results in a difference of $262 that gets to stay invested and grow.

The benefit of tax deferral is clear. With Roth accounts, it gets even better. Money inside a Roth will never be taxed again, so you keep 100% of all growth or income you earn. This is why tax-free accounts should generally be the last accounts you touch.

Incorporating Minimum Distributions

Once you reach age 70½, you must begin making Required Minimum Distributions (RMDs) from your tax-deferred accounts. Not doing so will result in a 50% penalty on the amount you should have withdrawn.

This changes things, but only slightly. At this point, you’d want to follow these steps:

  1. First, withdraw your RMDs.
  2. If you still have a shortfall, then pull from taxable accounts.
  3. Once depleted, go to your tax-deferred accounts.
  4. Lastly, pull money from tax-free accounts.

How to Supercharge Your Withdrawal Strategy With Betterment

You’ve seen the power of tax deferral, but if you’re a Betterment customer, there are other ways in which you can make your retirement income plan even more effective.

  • Specific Lot Selection: When you make a withdrawal, Betterment automatically sells investments that are at a loss first, minimizing your current tax hit.
  • Account Specific Asset Allocation: Betterment puts more tax-efficient asset classes in your taxable accounts such as municipal bonds.

Both of these strategies seek to further optimize your tax withdrawal strategies. Betterment executes seamlessly for you so that you can keep more money inside your accounts where it is able to grow.

The Problem of Rollercoaster Income

Unfortunately, putting a plan into action is always more complicated than in theory. In retirement, you will likely have multiple sources of non-investment income coming from Social Security, defined benefit pensions, rental income, part-time work, and/or RMDs.

However, these fixed income do not all begin or end at the same time, and some can vary from year to year, just as a rollercoaster goes up and down. This causes your tax bracket and your spending shortfall to fluctuate throughout retirement, adding a layer of complexity to your retirement income plan.

At first glance, these fluctuations seem to make creating a retirement income plan more difficult. Does the recommended strategy stated above, then, still apply? In most cases, yes. And with a little planning, you may actually be able use these swings to your advantage.

Smooth Out Bumps in Your Tax Bracket

For most years, Betterment recommends pulling from taxable accounts first, then tax-deferred accounts, and tax-free accounts last. However, you should look for abnormal years of high and low income fluctuations and their associated tax brackets, then plan accordingly.

By temporarily altering the above strategy, you can “smooth” out your tax bracket throughout retirement and reduce taxes.

Lower Income, Lower Tax Bracket

For example, some years you may find yourself in a lower bracket than usual. During these years, it may make sense to fill these low brackets with withdrawals from tax-deferred accounts before touching your taxable accounts, and possibly consider Roth conversions.

Common examples of low-bracket years may occur when:

  • You retire before you plan on claiming Social Security benefits.
  • You have large balances in your IRA/traditional 401(k) that will cause future RMDs to bump you into higher brackets.

Higher Income, Higher Tax Bracket

Conversely, you may have years where you are in an abnormally high tax bracket. In this case, it may make sense to pull from tax-free accounts first to minimize the effect of higher tax rates. Remember, higher taxes mean larger withdrawals and less money staying invested.

Common examples of high-bracket years occur when:

  • You sell a home or rental property with large capital gains.
  • You are working part-time in retirement and have a good year.
  • You lose a large deduction, e.g. due to paying off your mortgage.

Federal Income Tax Brackets (2016)

Tax Rate Single Married
10% $0 – $9,275 $0 – $18,550
15% $9,276 – $37,650 $18,551 – $75,300
25% $37,651 – $91,150 $75,301 – $151,900
28% $91,151 – $190,150 $151,901 – $231,450
33% $190,151 – $413,350 $231,451 – $413,350
35% $413,351 – $415,050 $413,351 – $466,950
39.6% $415,051 + $466,951 +

Source: Tax Foundation

Tax Diversification

The ability to pull from different accounts and smooth out your tax bracket, requires having money invested in at least two, but ideally three tax pools, which are taxable, tax-deferred, and tax-free.

We call this tax diversification, and it gives you the flexibility you need in retirement. Many customers have the majority of their savings in traditional 401(k)s and IRAs, and little money in Roth accounts. That means you have no choice in the order in which you withdraw from your investments, and you will pay taxes accordingly.

Most retirees should seek to have some money in all three tax pools. The benefits of investment diversification are well known and often talked about, but tax diversification is not something that is often discussed.

Generally, the only way to get money into each tax pool is by making direct contributions. However, a Roth conversion can be a powerful strategy to move money between tax pools. Building a tax-efficient retirement income plan is one of the main reasons tax diversification is so important.

Putting It All Together

Having a retirement income plan that incorporates taxes can extend the life of your portfolio. In general, we recommend you withdraw from your taxable accounts first, then your tax-deferred accounts, and lastly from your tax-free accounts. Implementing strategies such as tax loss harvesting, specific lot selection, and account specific asset allocation can further reduce or delay taxes.

You should also smooth out any bumps in your tax bracket during retirement by accelerating tax-deferred withdrawals during low tax years and choosing tax-free withdrawals during high tax years. To do this, you must have money in all three “tax pools” (taxable, tax-deferred and tax-free). We call this tax diversification.

While we suggest everyone consult a tax professional to discuss their particular situation, those with more complicated situations such as complex estate planning or charitable giving, may also want to consult an estate planning attorney. Even in such cases, we hope that these guidelines will still provide a solid foundation for your retirement income strategy.

This article is intended to be educational in nature and not relied upon as tax or investment advice.

1 As of the date published, long-term capital gains are generally taxed at 15%. However, if you fall into the 39.6% tax bracket, you will pay 20% on long-term capital gains. An additional 3.8% Medicare Surtax also applies to those whose MAGI is above $200,000 single/$250,000 married filing jointly. Still, the tax rate on these long-term capital gains will be lower than your tax rate on ordinary income, so the reasoning still applies. Conversely, taxpayers in lower brackets (15% or lower) pay 0% tax on long-term capital gains, making this strategy even more appealing.

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