Which Retirement Income Tax Strategy Is Right for You?

For many people, thinking about retirement simply means contemplating enjoyable ways of spending time during their golden years. What some people may not account for, however, is the impact taxation can have on savings, investments, and cash withdrawals.

Just as it is important to plan your investments—and it is never too soon to start—it is also wise to consider your strategy for withdrawals before you actually retire. This can help you align your anticipated tax burden with your financial goals, as well as give you ample time to consider your options.

In planning withdrawals from one or more retirement accounts, it is important to have a defined strategy for maintaining income and minimizing the impact of taxes, all while keeping your portfolio balanced appropriately for your risk tolerance. This is an excellent time to work with your financial advisor and/or tax professional, and no one strategy is right for everyone. With that in mind, here are four general strategies you may consider as you plan for retirement. (Please note that these are informational overviews only, and that the author does not provide legal or tax advice.)

1. Withdraw From Tax-Exempt Retirement Account Last

The least complex strategy of these four involves withdrawing from your accounts in an order that leaves tax-exempt accounts for last. In this scenario, you would first take required minimum distributions (RMDs) from your retirement accounts—thus avoiding any penalties for failing to withdraw your full RMDs.

Next, you would withdraw from taxable accounts until you have exhausted their balances. Utilizing taxable investments keeps more of your money parked where it has the potential to grow tax-deferred; any growth would enjoy higher potential for compounding interest, as taxes would not be levied until withdrawal.

Third, you would withdraw from tax-deferred traditional retirement accounts. This leaves your remainder, in this hypothetical scenario, invested in Roth accounts from which qualified withdrawals won’t be taxed, making them available without tax liability for predictable income, unexpected expenses, or passing on to your heirs.

This simple approach may be appealing, but it does come with at least one potential drawback: while withdrawing from tax-deferred accounts, your tax liability may increase enough to impact other aspects of your financial plan. If this concerns you, you may contemplate minimizing the likelihood of a shift in your tax bracket. (For related reading, see: Managing Retirement Account Withdrawals.)

2. Withdraw From Multiple Account Types

If avoiding a higher tax bracket is important to you, you may consider dividing up each of your withdrawals among several account types. By withdrawing from multiple accounts at a time, taking a portion of your needed money from each, you may be able to balance potential gains with tax liabilities on withdrawals from tax-deferred accounts. The goal here is maintaining a targeted marginal tax rate—one you would select before with withdrawals and which you would likely have to revisit before each tax year.

Another consideration you may want to plan for: Social Security benefits, for which the IRS maintains a unique taxation formula. To limit tax liability on these benefits, you may want to organize your withdrawals around a strategy built for this purpose. 

3. Minimize Tax Liability on Social Security Benefits

If you intend to minimize tax liability on Social Security benefits, you may consider distributing your withdrawals among multiple account types as you might if your goal was maintaining a targeted tax bracket. Social Security benefits are treated differently than ordinary income or investment gains by the IRS; as such, strategies for minimizing tax liability on Social Security benefits must account for additional income, whether from non-investment sources, retirement accounts or otherwise.

The same principle outlined in strategy #2 is at play here, but with one key difference: instead of targeting a specific tax bracket, you would focus on IRS thresholds for taxation on Social Security benefits. Your goal would be organizing withdrawals and resulting taxable income around maintaining your chosen bracket. As with each of the hypothetical scenarios here, this is a complex matter you should discuss with your tax professional and/or financial advisor. (For related reading, see: How Are Social Security Benefits Estimated & Taxed?)

If you find yourself wondering how these approaches could impact your capital gains tax rate, you might consider a strategy centered on capital gains tax liability.

4. Keep Capital Gains Taxation to a Minimum

Any increase in the value of your portfolio may be subject to capital gains taxes. As of the 2016 tax year, individuals in the 10% and 15% tax brackets were able to realize long-term capital gains or receive qualified dividends free of taxes. This means individuals with taxable income in these brackets for the 2016 tax year could have sold investments held longer than one year at a tax advantage during this period.

If a large percentage of an investor’s retirement assets were held in taxable accounts during this period, they could have incurred a potentially favorable tax scenario by selling longer-term stock holdings. This may not be true in any given year, and it is critical to keep abreast of IRS regulations on each aspect of your financial plan, as well as on each potential strategy you consider.

These are just a few of many potential strategies, and they are presented merely to help you start considering your options as you begin to outline a financial plan. Consult with a tax professional of your choice when considering the role that present and future taxes may play in your plans for retirement or otherwise.

(For more from this author, see: How to Build Your Optimally Balanced Portfolio.)


The author is not affiliated with, nor endorsed by, the Social Security Administration or any other government entity.