Which retirement withdrawal strategy is best for you?

As you approach retirement, it’s important to develop a retirement income strategy. Developing tax-efficient retirement strategies to plan your source of income should be an annual process. Every year your taxable income and possibly your living expenses change. The tax code has also changed repeatedly over the last decade, so it is important that your withdrawal strategy is up to date.

Retirement Income Strategies: How Different Accounts Are Taxed

Retirement funds are typically held in three different types of accounts:

• Tax-deferred (pre-tax IRA, 401(k), 403(b), etc.)
• Tax-free (Roth IRA and other Roth accounts)
• Taxable account (brokerage account)

The retirement withdrawal strategies available to you depend on how diversified you are from a tax perspective. Having significant retirement savings in each account type generally opens up more planning options.

Tax-advantaged accounts These include traditional IRAs and pre-tax 401(k) plans. These are called tax-deferred because (as the name suggests) taxes are deferred until the money is withdrawn. So if you make a withdrawal in retirement, the entire amount will be taxed as ordinary income. Tax-deferred retirement accounts also require minimum distributions (RMDs) that must be factored into retirement income planning discussions.

Tax-free accounts These include Roth IRAs, Roth 401(k) and other types of Roth accounts. As long as investors meet the required five-year holding period and defer distributions until age 59 1/2, withdrawals are tax-free.

A brokerage account is a taxable investment account. Although it is not a retirement account, a Brokerage account is often used by wealthy investors to supplement their retirement savings. Brokerage accounts have no tax deferral, so capital gains, interest, and dividends are taxable each year. You’ll likely have to pay some taxes each year even without cashing out, but if you hold positions for more than a year, you can benefit from favorable long-term capital gains rates.

Having assets in all three types of accounts provides the opportunity to develop tax-efficient retirement withdrawal strategies.

Tax-efficient withdrawal strategies in retirement

The best way to meet your income needs in retirement is a mix of art and science. Consider all factors relevant to your situation as well as your long-term goals.

Consider this illustrative example and corresponding tax-efficient retirement strategies.

Couple aged 60 with significant taxable and tax-deferred retirement savings

The couple has options. They can earn retirement income from their brokerage work, pre-tax IRAs, or both. Required minimum distributions do not begin until age 75 for these retirees. Under the traditional rule of thumb, the couple would first spend their taxable assets before accessing the retirement account.

But is this really the most tax-efficient withdrawal strategy?

That way, they would likely be setting themselves up for a significant drop in taxes if the RMDs were implemented. Large forced distributions would hardly offer them any hiding place from a tax perspective. In addition, they could miss out on opportunities to benefit from low tax years by then.

Instead, the couple could consider one or more of the following approaches each year:

• Make dividends and capital gains distributions in cash rather than reinvested stock
• Evaluate your tax situation annually and begin withdrawing funds from pre-tax assets to take advantage of low tax brackets and control entry into the next higher tax bracket
• If there is a need for additional income, further analysis is required. When deciding which asset classes need to be rebalanced, consider the expected taxable income for the year, the relative breakdown between account types, and unrealized capital gains

Other withdrawal strategies to consider when cash flow needs are met

If generating additional income is not necessary, consider the benefits of a Roth conversion in a given year. Roth conversions are very flexible, making it possible to convert just enough to fill the current marginal tax bracket.

Also consider the pros and cons of taking profits from taxable accounts to fill the 0% capital gains tax bracket. In 2024, married couples filing jointly can have income up to $94,050 and pay 0% on long-term capital gains.

Tax-deferred accounts are not the most efficient solution for every goal

If one of your primary goals is to preserve your wealth for your children, the best withdrawal strategy for your goals may not be the most tax efficient.

Non-spousal beneficiaries can no longer extend an IRA over their lifetime. Instead, they must draw down the entire account within 10 years and may also be subject to annual RMDs. For beneficiaries in their prime working years, this could significantly complicate their tax situation. Forced withdrawals can also lead to spending incentives.

By relying more heavily on retirement accounts throughout your life, you may be able to preserve more taxable assets for your children. Most inherited brokerage accounts come with an “enhanced” cost basis. A step-up in basis values ​​an asset at the time of your death, not at its original cost. Ignoring the investment benefits and other factors means your heirs could technically close the account shortly after your death and pay little to no taxes.

The right approach for you and your family always depends on your specific situation, your goals and current tax laws. You should also weigh your marginal tax bracket versus what you expect your children’s tax bracket to be to determine what is likely to produce the largest after-tax inheritance.

Balancing tax optimization with the realities of retirement planning

Trying to perfectly optimize your retirement savings plan is a difficult task. And with so many factors beyond your control, such as market conditions and costs, fully optimizing the timing of your withdrawal may not be realistic.

Also consider your cash balances, timing of expenses, and your desire for regular income. Many retirees like the idea of ​​living off their portfolio income, but dividends vary, as does the cost of living. And as mentioned, periodic cost basis resets and controlled rebalancing is usually a feature, not a bug. It can also help reduce trading costs and sales.

Because everyone’s circumstances and goals are different, you should work with your financial and tax advisor to determine the best approach for your individual situation.