Prior Planning Needed to Determine Most Tax-Efficient Method for Withdrawing Retirement Funds

By Ken Bloom, J.D., LLM
For most investors, making sure they save enough money to retire comfortably is the focus of their investment strategies. But once you have reached retirement, you now need to determine which retirement account you should withdraw from in order to fund your retirement. The key is to sequence your withdrawal to maximize the value of your account. 

Often times the combination of social security and/or pension benefits may be sufficient to maintain your lifestyle. In that case you may not need to take a distribution from your other investments for living expenses. That, of course, is the best case scenario. But once you need to withdraw funds for retirement, the general rule is to withdraw money from your taxable accounts first before you withdraw from your retirement accounts (IRA, 401k, etc.). The longer you are able to keep money in your tax-deferred or non-taxable accounts the more these accounts will be worth and the more you will be able to withdraw later. In view of the increasing costs of retirement and longer life expectancies this is an important consideration.

So, for example, if you need $1,000 a month during retirement, it normally makes more sense for you use your taxable accounts first rather than withdrawing from your IRA or 401(k). That’s because you would only have to pay tax on the “profit” on the investments which are normally taxed as a capital gain. If there is a loss on the investment you sell then there is no taxable event. However if you withdrew the same money from an IRA the entire amount of the withdrawal is taxable as ordinary income. To net an extra $1,000 per month a tax payer in the 20% tax bracket would be required to withdraw an extra $250 per month (or $3,000 per year) to cover the taxes due on the withdrawal. Over time this extra withdrawal will result in a meaningful diminution of the value of the account. In addition the withdrawal may cause all of your income to be taxed at a higher marginal tax rate.

Required Minimum Distributions

While this general rule may apply to many retirees, there are certain situations that may dictate a different withdrawal strategy. Once you reach age 70 ½, the IRS requires that you withdraw a certain amount from your tax deferred retirement plans (“RMD”). The amount you must withdraw is based on your life expectancy and the assets in your portfolio as of December 31 each year. Even if you don’t need the money you are required to take a withdrawal from your accounts so the government can tax it as income. The good thing is that you are not required to spend that money, so you can actually re-invest it into a taxable account after you withdraw the funds.

Roth IRAs provided an important exception to the rules regarding RMDs. There are no required distributions from a Roth IRA. Furthermore, if you are married your spouse does not have to withdraw the money either (however your beneficiaries will have to withdraw from the Roth IRA following both of your deaths although the distribution will be tax free to them as well). Withdrawals from a Roth IRA are generally tax free because you have already paid the taxes on these funds up-front.

Tax Bracket Impacts Withdrawal Strategy

Obviously, a part of the withdrawal strategy is based on an individual’s tax bracket. If, for example, you are a low tax bracket it may make sense to instead take money from your IRA or 401(k) accounts first. By doing that, you are being taxed on the money at a low rate. Since the minimum required distribution from your IRA normally increases each year as your life expectancy decreases, withdrawing before age 70 ½ will reduce the amount of your required minimum distribution in later years. This could prevent your income from being taxed at higher rates.

One thing I often recommend for many retirees who don’t really need extra income during retirement and want to leave as much money as possible to their children upon death is to convert a portion of their investments to a Roth IRA. By doing this, you pre-pay the taxes for your children, while also reducing the RMDs that you have to withdraw each year on your traditional IRA or 401(k) accounts.The bottom line is that planning is the key to make sure your investments are sufficient to maintain your lifestyle in retirement. In addition to having a plan to minimize your taxes, you should also develop a household budget that you can stick to during retirement to avoid excess spending. The combination of budgeting and tax planning is the best way to ensure you won’t run out of money during retirement.