Pay Fewer Taxes on Your Retirement Income With This Withdrawal Strategy

For retirees with assets in taxable investment accounts, traditional retirement accounts and Roth IRAs, Fidelity says a proportional withdrawal strategy may help reduce taxes throughout retirement and potentially extend the life of a portfolio, depending on an individual’s financial situation. Rather than withdrawing assets from one account at a time, this approach spreads withdrawals across multiple account types from the start of retirement. ¹

A financial advisor can help you withdraw your retirement assets in a tax-efficient manner and provide other retirement advice.

This Common Withdrawal Strategy May Be Costing You

As Fidelity notes, tax professionals often recommend withdrawing assets from taxable accounts first, followed by tax-deferred accounts such as traditional 401(k)s and IRAs, and finally Roth IRAs. This approach allows Roth assets to continue growing tax-free for longer, and Roth IRAs are generally not subject to required minimum distributions during the original owner’s lifetime.

However, relying exclusively on one account type at a time may not always produce the most tax-efficient outcome. For example, drawing only from taxable accounts early in retirement could preserve tax-deferred savings, but it may also allow balances in traditional retirement accounts to continue growing. Larger balances can eventually lead to larger taxable withdrawals, including required minimum distributions (RMDs) once they begin.

Withdrawals from taxable brokerage accounts also aren’t necessarily tax-free. Selling appreciated investments may trigger capital gains taxes, depending on how long the investments were held, the size of the gain and your overall taxable income for the year.

Because of these factors, some retirees choose to spread withdrawals across multiple account types instead of exhausting one account before moving to the next. For retirees with multiple account types, this approach may help smooth taxable income over time and reduce lifetime taxes, although the results depend on an individual’s financial situation.

Proportional Withdrawals: A Tax-Savvy Alternative

Fidelity suggests another approach that may improve tax efficiency for some retirees: taking withdrawals from taxable, tax-deferred and Roth accounts at the same time instead of spending down one account before moving to the next. Spreading withdrawals across different account types can help smooth taxable income over the course of retirement rather than creating periods of unusually high taxable income.

Proportional withdrawals may be most effective for retirees with moderate taxable income. Those who expect unusually large long-term capital gains may benefit from a different withdrawal strategy, depending on their circumstances.

Depending on your circumstances, this approach may also help reduce the impact of required minimum distributions by avoiding unnecessarily large balances in tax-deferred accounts before RMDs begin. It may also help manage the taxation of Social Security benefits, Medicare premium surcharges and other tax-related thresholds that are based on income.

While this approach may mean paying some taxes throughout retirement instead of delaying them, Fidelity says it can help smooth taxable income over time. Rather than allowing taxes to build up later in retirement as withdrawals from tax-deferred accounts increase, spreading withdrawals across different account types may reduce lifetime tax costs for some retirees. Whether this approach produces tax savings depends on factors such as your account balances, income needs, filing status and future tax laws.

How to Implement a Proportional Withdrawal Strategy

Setting up a proportional withdrawal strategy involves taking consistent percentages from each type of account, rather than depleting one source before moving on to the next. This is not the only retirement withdrawal strategy but, if you think it works for you, here’s what you’d need to do:

1. Calculate your account proportions: You would start by determining the total value of all your retirement accounts and assign a percentage to each. For example, if you have $500,000 total, with $200,000 in taxable accounts, $250,000 in traditional 401(k)s and $50,000 in Roth IRAs, your respective proportions are 40%, 50% and 10%.
2. Withdraw based on those percentages: One approach is to withdraw from each account based on its share of your overall retirement savings, while adjusting as needed for required minimum distributions and changes in your tax situation. For example, if you need $50,000 for the year, you might withdraw about $20,000 from your taxable account, $25,000 from your traditional 401(k) and $5,000 from your Roth IRA. In practice, however, these percentages may need to change over time, especially after required minimum distributions begin or if your tax situation changes.
3. Use tools to automate or track withdrawals: Many financial institutions and custodians offer automated withdrawal tools or calculators that can maintain your desired proportions. Platforms like Fidelity’s Retirement Income Planner, Vanguard’s withdrawal calculators or SmartAsset’s planning tools, like our retirement and RMD calculators, can help estimate the most tax-efficient mix for your situation.
4. Rebalance annually: Over time, investment performance will cause each account’s balance to shift. Revisit your withdrawal proportions each year to ensure they still align with your original percentages. Rebalancing keeps your strategy aligned with both your investment goals and tax efficiency.

Run the numbers with our income tax calculator to see how different withdrawal strategies and asset locations can affect your tax bill year by year.

Tax Implications By Account Type

Knowing how each account type is taxed can help you manage your total tax bill in retirement. Different withdrawal sources are taxed in different ways, which is why proportional withdrawals can help you smooth your tax liability over time.

• Taxable Accounts: Withdrawals from brokerage accounts can trigger capital gains taxes. Long-term capital gains (on assets held for more than a year) are generally taxed at 0%, 15%, or 20% depending on your income level. Dividends may also be taxed, though qualified dividends often receive favorable rates.
  
• Traditional IRAs and 401(k)s: Withdrawals are taxed as ordinary income since contributions were made pre-tax. The exact rate depends on your tax bracket at the time of withdrawal. These accounts are also subject to required minimum distributions (RMDs) starting at age 73.
  
• Roth IRAs: Qualified withdrawals, meaning you’re over 59 ½ and the account has been open for at least five years, are tax-free. Because Roth IRAs aren’t subject to RMDs during your lifetime, they can be strategically used to control taxes and preserve assets for later years or heirs.

The table shows how the same withdrawal amount may be taxed depending on the type of retirement account.

Note: The tax treatment shown is an example. Your actual tax liability depends on factors such as your income, filing status, deductions, investment gains and applicable state tax laws.

How Your Withdrawals Affect Social Security Taxation

The account you withdraw from can affect how much of your Social Security benefit becomes taxable. The IRS uses a measure known as combined income. This includes your adjusted gross income, tax-exempt interest and half of your annual Social Security benefits.

For single filers, up to 50% of benefits may be taxable when combined income falls between $25,000 and $34,000. Above $34,000, up to 85% may be taxable. For married couples filing jointly, the corresponding thresholds are $32,000 and $44,000.

Withdrawals from traditional IRAs and 401(k)s generally increase adjusted gross income, so they can push more of your Social Security into the taxable range. Once required minimum distributions begin, those withdrawals may also limit how much control you have over your taxable income. Qualified Roth IRA withdrawals generally are not included in adjusted gross income, which can help keep combined income lower for Social Security tax purposes.

This does not mean retirees should always favor Roth withdrawals. Drawing too heavily from a Roth account early could reduce the amount of tax-free money available later. The better approach may involve adjusting withdrawals each year based on required distributions, spending needs and how close combined income is to the Social Security thresholds.

Taxpayers age 65 and older may also qualify for an additional deduction of up to $6,000 through 2028, subject to income limits. This deduction can reduce taxable income and the resulting tax bill, but it does not lower adjusted gross income or change the combined-income calculation used to determine whether Social Security benefits are taxable.

Bottom Line

For retirees with assets spread across multiple accounts, including taxable brokerage accounts, traditional 401(k)s and Roth IRAs, Fidelity found that a proportional withdrawal strategy may help reduce lifetime taxes and potentially make retirement savings last longer, depending on an individual’s circumstances. This approach relies on making withdrawals from each of your accounts simultaneously based on that account’s percentage of your overall savings. A financial advisor can provide additional insights into the best tax and retirement strategies for your budget.

Retirement Planning Tips

• Planning for retirement can be complicated and overwhelming. A financial advisor can help you make important financial decisions related to your retirement plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Tracking your progress toward reaching a savings goal is critical. SmartAsset’s Retirement Calculator can help you estimate how much you’ll have in savings when the time comes to retire and getting a better sense of where you stand.

Photo credit: iStock.com/Luke Chan, iStock.com/shapecharge, iStock.com/MCCAIG