- How and when you choose to withdraw from various accounts in retirement can impact your taxes in different ways.
- Consider a simple strategy to potentially pare taxes in retirement: Take an annual withdrawal from every account based on that account's percentage of overall savings.
- Don't go it alone. Be sure to check with a tax advisor for help reducing taxes and have a plan to manage withdrawals from retirement accounts.
Ways to withdraw money in retirement
It's official: You're retired. That probably means no more regular paycheck, and that you may need to turn to your investments for income. But remember—the impact of taxes is just as important to consider now as it was when saving for retirement.
The good news is that in retirement there may be more options to increase after-tax income, especially when savings span multiple account types, such as traditional retirement accounts, Roth accounts, and taxable savings like brokerage or savings accounts. The not-so-good news is that choosing which accounts to draw from and when can be a complicated decision.
"Many people are seeking ways to help reduce the taxes that they will pay over the course of their retirement," says Andrey Lyalko, vice president of Fidelity financial solutions. "Timing is critical. So, how and when you choose to withdraw from various accounts—401(k)s, Roth accounts, and other accounts—can impact your taxes in different ways."
Finding the right withdrawal strategy
Let's start with a key question that many retirees ask: How long will my money last in my retirement?
As a starting point, Fidelity suggests you consider withdrawing no more than 4-5% from your savings in the first year of retirement, and then increase that first year's dollar amount annually by the inflation rate. But from which accounts should you be taking that money?
Traditionally, many advisors have suggested withdrawing first from taxable accounts, then tax deferred accounts, and finally Roth accounts where withdrawals are tax free (see illustration below). The goal: to allow tax-deferred assets to grow longer and faster.
For most people with multiple retirement saving accounts and relatively even retirement income year over year, a better approach might be proportional withdrawals. Once a target amount is determined, an investor would withdraw from every account based on that account’s percentage of their overall savings.
The effect is a more stable tax bill over retirement, and potentially lower lifetime taxes and higher lifetime after-tax income. To get started, consider these 2 simple strategies that can help you get more out of your retirement savings, depending on your personal situation.
Traditional approach: Withdrawals from one account at a time
To help get a clearer picture of how this could work, let's take a look at a hypothetical example: Joe is 62 and single. He has $200,000 in taxable accounts, $250,000 in traditional 401(k) accounts and IRAs, and $50,000 in a Roth IRA. He receives $25,000 per year in Social Security and has a total after-tax income need of $60,000 per year. Let's assume a 5% annual return.
If Joe takes a traditional approach, withdrawing from one account at a time, starting with taxable, then traditional and finally Roth, his savings will last slightly more than 22 years and he will pay an estimated $74,000 in taxes throughout his retirement.
Note that with the traditional approach, Joe hits an abrupt "tax bump" (see red circle in chart) in year 8 where he pays over $5,000 in taxes for 11 years while paying nothing for the first 7 years and nothing when he starts to withdraw from his Roth account.
Now let's consider the proportional approach. As you can see in the graph above, this strategy spreads out and dramatically reduces the tax impact, thereby extending the life of the portfolio from slightly more than 22 years to slightly more than 23 years. "This approach provides Joe an extra year of retirement income and costs him only $46,000 in taxes over the course of his retirement. That's a reduction of almost 40% in total taxes paid on his income in retirement," explains Lyalko.
By spreading out taxable income more evenly over retirement, you may also be able to potentially reduce the taxes you pay on Social Security benefits and the premiums you pay on Medicare.
Expecting relatively large long-term capital gains?
Spreading traditional IRA withdrawals out over the course of retirement lifetime may make sense for many people. However, if an investor anticipates having a relatively large amount of long-term capital gains from your investments—enough to reach the 15% long term capital gain bracket threshold—there may be a more beneficial strategy: First use up taxable accounts, then take the remaining withdrawals proportionally.
The purpose of this strategy is to take advantage of zero or low long-term capital gains rates, if available based on ordinary income tax brackets. Tax rates on long-term capital gains (applied to assets that are held over 1 year) are 0%, 15% or 20% depending on taxable income and filing status (see tables). Assuming no income besides capital gains, and filing single, the total capital gains would need to exceed $38,600 before taxes would be owed.
One strategy for retirees to help reduce taxes is to take capital gains when they are in the lower tax brackets. For example, single filers with taxable income less than $38,600, are in the 2 lower tax brackets. That equates to a 0% tax on capital gains. If taxable income is between $38,601 and $425,800, long-term capital gains rate is 15%. Remember, the amount of ordinary income impacts long-term capital gain tax rates.
Meet Jamie, a hypothetical single filer with $21,525 in ordinary income and $5,000 in long-term capital gains. After taking advantage of the $12,000 standard deduction, she will have $9,525 ($21,525 - $12,000) subject to a 10% income tax, but her $5,000 in capital gains will be taxed at 0%. Estimated total tax due: $953.
Now meet David, a hypothetical single filer who has $50,601 in ordinary income and $5,000 in long-term capital gains. After taking out $12,000 in standard deduction; his first $9,525 of taxable income will be taxed at 10%, the remaining $29,076 of ordinary income at 12%, and, because of his higher income tax bracket, the $5,000 in long-term capital gains will be taxed at 15% or $750. His estimated total tax due: $5,192.
The big difference: Jamie pays zero on her long-term capital gains because her income is below that key threshold of $38,600, but David pays 15% on his $5,000 because of his higher earnings.
Investors that can take advantage of the 0% long term capital gain rate may want to consider using their taxable account first to meet expenses. Once the taxable account is exhausted, the proportional approach can then be applied.
Additionally, this strategy allows investors to keep their assets in more tax-efficient accounts for a longer period of time by delaying withdrawing from their traditional and Roth accounts where the assets can grow tax-deferred or tax-exempt, respectively.
Optimizing withdrawals in retirement is a complex process that requries a firm understanding of tax situations, financial goals, and how accounts are structured. However, the 2 simple strategies highlighted here could potentially help reduce the amount of tax due in retirement.
It's important to take the time to think about taxes and make a plan to manage withdrawals. Be sure to consult with a tax or financial advisor to determine the course of action that makes sense for you.
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