Tax-Efficient Withdrawal Strategies

Retirement income and the US tax code are both complex topics in their own right. When you combine them, it’s easy to become overwhelmed. Something as seemingly little as which accounts a retiree withdraws from initially — and in what amounts — can significantly impact their tax bill throughout retirement and the success or durability of their retirement funds.

During retirement, there may be additional opportunities to grow after-tax income, primarily if funds are spread across different account types, such as traditional retirement accounts, Roth accounts, and taxable accounts. The not-so-positive side is that choosing which accounts to draw from and when might be a difficult decision.

It’s critical to understand your likely tax rate in retirement. One essential retirement withdrawal technique is keeping your income steady and in the lowest tax bracket possible. This entails balancing your income from taxable and non-taxable sources to prevent swinging from one extreme to the other (paying zero tax one year and a high tax rate the next).

1. Withdrawals from only one account at a time

Let’s look at a hypothetical example to get a better idea of how this could work: If you are 62 years old and unmarried, you have around $200,000 in taxable accounts, $250,000 in regular 401(k) and IRA accounts, and $50,000 in a Roth IRA.

You may get $25,000 in Social Security each year and have an after-tax income requirement of $60,000 yearly. Let’s assume a 5% annual return. If you go the typical route, taking from one account at a time, beginning with taxable, then traditional, and ultimately Roth, your savings may last somewhat longer than 22 years, and you will pay an estimated $59,000 in taxes throughout your retirement.

2. Withdraw anything that keeps you in a low tax bracket.

If you are older than 59/2 and younger than 73, you can take money from retirement plans without incurring the 10% early withdrawal penalty, but you are not compelled to take distributions from the account. Some people choose to begin withdrawals in their 60s, particularly if they are already retired and at a low tax rate.

You can withdraw only enough to pay a low dividend tax rate during your 60s because distributions are not required. In retirement, you can choose systemic withdrawals from your IRA. With this method, you establish a regular plan for withdrawing a specified amount from your IRA. It provides a constant income similar to a paycheck. Still, it may be unsustainable if your portfolio is too volatile and your withdrawal rates are too high as a percentage of the account value.

3. Traditional wisdom regarding withdrawal strategies.

This withdrawal technique depletes taxable accounts first, then tax-deferred accounts, and lastly, Roth accounts. This method aims to maximize the advantages of tax-deferred growth in tax-deferred accounts such as standard IRAs, 401(k)s, and Roth accounts.

4. Include Charitable Giving

If you are ready to donate the money to charity, you can avoid paying income tax on IRA withdrawals. IRA owners 70 1/2 and over can send up to $100,000 per year ($200,000 for couples) directly from an IRA to an eligible charity without incurring income tax liability. An eligible charity distribution will also fulfill an IRA’s minimum payout requirement. Donating money to charity is not considered income and will not appear on your tax return. This is one approach to help a charity or cause while simultaneously managing your taxable income in retirement.

5. Proportional withdrawal strategy.

This method draws from taxable and tax-deferred accounts first, followed by Roth funds. Withdrawals from taxable and tax-deferred accounts are made in proportion to the account balance at the withdrawal time.  Withdrawals from Roth accounts are made when taxable and tax-deferred accounts have been depleted. All else being equal, this simple rules-based method will withdraw from traditional IRAs earlier than popular wisdom, especially if a retiree has a high concentration of assets in tax-deferred accounts.

6. Individualized withdrawal plan.

A more customized technique handles withdrawals in a way that directly affects a retiree’s tax bracket. This technique withdraws funds from tax-deferred accounts until any additional distribution will force the retiree into a higher tax bracket.

If additional withdrawals are required, they are made from taxable funds first, followed by Roth accounts. This is an example of more individualized counsel, and it may be executed with the assistance of a financial advisor or tax specialist.

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