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4 Tips to Optimize Your Retirement Account Withdrawals (And Reduce Taxes)

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This is how to make sure your savings lasts the longest.

If you’re planning to retire within the next few years, you’ve undoubtedly considered when you should start making withdrawals from your retirement accounts.

However, the order in which you withdraw from your accounts is also important -- it could let your tax-advantaged accounts grow to their full potential, make your savings last and even save you money on taxes.

Throughout this guide, we’ll look at generic examples to give you an idea of how to start withdrawing from your investments, your 401(k)/traditional IRA and your Roth IRA, as well as when to begin accepting Social Security.

To make this guide as straightforward as possible, we’ll assume you’re above age 59.5. If you withdraw from most retirement accounts before then, you’re subject to paying tax on the additional income, as well as up to a 10% early withdrawal penalty.

Regardless of when you retire, once you hit age 70.5, you’ll be subject to required minimum distributions (RMDs -- the amount you’re required to withdraw from your retirement accounts each year) from most retirement accounts.

The Optimal Order to Withdraw From Your Retirement Accounts

First things first: This is not meant to serve as a one-size-fits-all approach for everyone. Figuring out a strategy that works best for your specific situation is complicated and personal.

To make sure you get the best advice possible, we recommend speaking with a financial advisor. These experts can help you analyze your accounts and determine the best way to allocate your savings withdrawals as you age. In many cases, they can keep you from making simple mistakes that could result in higher taxes and fees.

If you want to get matched with an advisor to optimize your retirement-savings plan, try our simple financial advisor matching tool. All you have to do is answer these few questions and we’ll match you with as many as three advisors in your local area.

1. Start With Your Investments

By withdrawing from your investments first, you’re giving your retirement accounts more time to compound interest and keep growing.

Whether you have mutual funds, a brokerage account, ETFs, stocks or bonds, they’re all taxable, so you’ll have to pay capital gains taxes on any withdrawals. Additionally, some investments also require you to pay taxes on distributions each year, like some mutual funds. Therefore, it makes sense to use the money in these accounts first.

If you can get by on what’s in these accounts first, it allows your money in other tax-advantaged, interest-accruing accounts to keep growing, without you having to pay tax on their growth each year.

This step is especially important if the money can carry you until you turn 70 ½, when you have to start taking RMDs from your retirement accounts.

Here’s an example: Let’s say your investment portfolio has $100,000 in it (and started as $1,000 -- nice gains!). Assuming you’ve had the investment for longer than a year, you’ll be assessed the long-term capital gains rate of 15%. At this rate, you’d pay $14,850 in taxes (plus applicable state and local taxes -- so about $25,046 if you live in New York City).

Obviously, the more valuable your investments, the more you’re likely to pay in capital gains tax. However, this tax burden could be offset by the growth that’s still occurring in your other retirement accounts that you’ve yet to tap into.

For comparison: While not advisable, if you have $500,000 in your 401(k) and were to take out $100,000 at 65, it’d be taxed as income. Assuming it’s your only source of income (which is unlikely), you’d pay just under $24,000 in tax, technically less than the capital gains tax.

However, if you were to leave the $500K in your account and make no more contributions to it, the balance could grow to over $700,000 by the time you turn 70 (at a 7% rate of return). Basically, your account will miss out on the chance to keep compounding interest and growing until you have to start taking RMDs.

A financial advisor can help guide you through the best way to withdraw from your portfolio in the most tax-efficient way and further explain the benefits of letting your 401(k) continue to grow.

2. Move on to Your 401(k) and IRA

Once you’ve exhausted your investment portfolio, it’s time to move on to your tax-deferred retirement savings accounts: your traditional 401(k) or IRA.

Since these accounts allowed you to set aside pre-tax money from your paycheck during your working years, you’ll be paying tax on any withdrawals you make. Unlike taxable investment accounts, you won’t be charged income tax or capital gains tax as your 401(k) account grows each year.

However, things change once you start receiving distributions from the 401(k). As you pull money out, you’ll owe incomes taxes on the funds. Some 401(k) plans will automatically withhold 20% or so of your account to pay for taxes. You’ll want to check with your plan provider to see how your particular 401(k) works.

There isn’t a separate 401(k) withdrawal tax, so withdrawals are taxed as income. At the very least, you’ll pay federal income tax on the amount you withdraw each year. Retirees who live in states that have additional income taxes, such as New York, California and Minnesota, will have to pay that as well.

If you’re using your 401(k) to replace your previous salary, you can expect similar taxes as years prior. However, if you’re planning on living on less, and limit your withdrawals, you might find yourself in a lower tax bracket. If that’s the case, you’ll owe less in taxes because of your income drop.

Once you hit age 70 ½, you’ll have to begin RMDs. So, if you have $100,000 in your 401(k), your RMD will be around $3,500/year. You’ll also have to pay taxes on these withdrawals.

Speaking with a financial advisor can help you develop the most tax-efficient plan for withdrawing money from your 401(k) so you can capitalize on the money you take out and not overpay on taxes.

3. Wait to Tap into Your Roth

This is important: Put off withdrawing money from your Roth IRA as long as you possibly can.

You opened this account because of tax advantages: You paid taxes up front so you wouldn’t have to pay them later, and potentially at a higher rate. That means you can take money out of your Roth IRA and it won’t count as taxable income.

The beauty of saving your Roth IRA for last, aside from not having to pay tax on withdrawals, is it will continue to grow tax-free as you tap into your other accounts. Since a Roth IRA holds after-tax funds and the IRS doesn’t need to tax it again, you also don’t need to take RMDs from a Roth IRA. This means you can keep waiting to take money out as long as you want and interest will continue compounding.

Another perk of Roth accounts? You can continue contributing to a Roth IRA no matter how old you are. So just as you can take the money out whenever you want, you can keep making contributions, even once you’re technically in retirement.

4. Stall on Accepting Social Security Benefits

When it comes to Social Security, you’ll be able to start accepting benefits once you turn 62.

This is not the optimal time to start accepting them. You will be leaving money on the table. If you can afford to wait, your optimal age is 70.

Here’s why: If you want your maximum Social Security benefits, you’ll need to work until your “full retirement” age.

For a long time, you had to be 65 years old to receive full benefits, until U.S. Congress pushed through the Social Security Amendments of 1983. The SSA clearly indicates that, aside from extenuating circumstances, the earliest anyone can retire to start receiving Social Security is 62 years old, and the person loses 30% of the benefits for that year. Full retirement age for those born between 1943 and 1954 is 66, and 67 for those born after 1960. For those born between 1955-1959, the full retirement age is 66, but the month varies.

Your benefits at age 62, 66 or 67 are not your maximum benefits, though. The longer you hold off from activating your Social Security benefits up to age 70, the greater your return. The maximum Social Security retirement benefit kicks in at age 70.

Each year after full retirement, your payout increases by a certain percentage based on specific criteria. To maximize on this strategy, we recommend holding off until you are 70 — payments will be the highest possible, increasing by 8% each year you wait. However, there are no additional increases after 70, so you’re best off cashing out as soon as your birthday hits.

Bonus: Since your Social Security disbursement is based on the amount of money you make over the course of 35 years, you will increase your entitlement by earning as high a salary as possible for as long as you can. Not only will this boost the final amount you receive, it will also give you a chance to eliminate low-wage earning years from the 35-year pool.

Next Steps

Determining the optimal sequence to withdraw money from your retirement accounts is different for everyone.

To make sure you set yourself up with the best possible plan, we recommend speaking with a financial advisor, and actually designed a tool to match you with the top advisors in your area.

Here's how it works:

  1. Answer these few easy questions about your current financial situation.
  2. Sit back while we match you with up to three advisors who can provide expertise based on your specific goals. It only takes a minute.
  3. Check out the advisors' profiles, interview them on the phone or in person and choose who to work with in the future.

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