Tax-Efficient Withdrawal Sequencing: Taxable vs. Roth vs. Traditional
Achieving financial security in retirement requires more than diligent saving; it requires thoughtful planning around how and when you withdraw from your retirement accounts. Strategic withdrawal sequencing between taxable accounts, traditional (tax-deferred) retirement accounts, and Roth (tax-free) accounts can dramatically enhance your financial outcome, reduce your tax burden, and maximize the longevity of your savings.
These withdrawal strategies assume that you start your withdrawals after age 59 ½ which eliminates most IRA and Roth IRA early withdrawal penalties. Different strategies would apply if you are withdrawing from your investment account before this.
Clearly Understanding Your Account Options
To effectively strategize, it’s crucial to grasp the distinct tax treatments associated with each account type:
- Taxable Accounts: Brokerage accounts funded with after-tax dollars. Gains and dividends are taxed annually, sometimes at favorable long-term capital gains rates.
- Traditional Retirement Accounts (IRA, 401(k)): Contributions are usually pre-tax, allowing tax-deferred growth. Withdrawals during retirement are fully taxable at ordinary income rates. RMDs start at age 73 (age 75 for those born in 1960 or later under SECURE Act 2.0).
- Roth Retirement Accounts (Roth IRA, Roth 401(k)): Contributions are made with after-tax dollars; growth and qualified withdrawals are entirely tax-free. Crucially, Roth IRAs have no lifetime Required Minimum Distributions (RMDs), and Roth 401(k)s are similarly exempt from RMDs starting in 2024.
The Power of Proper Withdrawal Sequencing
Thoughtful sequencing can preserve your wealth in three important ways:
- Minimizes Overall Taxes: By carefully withdrawing funds, you leverage lower tax brackets and avoid unnecessary taxation.
- Enhances Tax-Free Growth: Keeping your Roth funds invested as long as possible allows your wealth to compound without tax erosion.
- Controls Future RMDs: Proactive withdrawal or Roth conversions from traditional accounts can substantially reduce mandatory future withdrawals and associated taxes.
Withdrawal Sequence Strategy
To maximize efficiency, consider this 4-step sequence:
- Prioritize Required Minimum Distributions (RMDs)
Begin by taking mandatory RMDs from traditional accounts at age 73 (age 75 by 2033), ensuring you avoid steep penalties that can reach up to 25% of missed distributions.
- Utilize Taxable Accounts Next
Once RMDs are covered, taxable accounts should be your next source. These accounts offer more favorable tax treatments, particularly with long-term capital gains. Leverage tax-loss harvesting techniques to offset gains and manage overall taxable income effectively.
- Carefully Draw from Traditional Accounts
Withdraw just enough from traditional accounts each year to “fill” lower tax brackets without unnecessarily pushing into higher marginal brackets. This “bracket-filling” strategy maintains a controlled tax environment.
- Preserve Roth Accounts for Last
Finally, Roth accounts are best preserved until other sources are exhausted, allowing them to grow uninterrupted. Withdraw from Roth accounts strategically, particularly in years with higher income needs or to manage tax-bracket pressures.
Key Consideration: The Roth Five‑Year Rule
To enjoy tax‑free earnings on Roth IRA withdrawals, your account must be open at least five years (counted from January 1 of the year of your first contribution). Each Roth conversion also starts its own five‑year clock to avoid a 10% penalty on converted amounts before age 59½.
Advanced Strategies to Increase Tax Efficiency
Strategic Roth Conversions
If you hold hefty IRAs or 401(k)s and expect rising tax rates from larger RMDs or pensions, Roth conversions can be a game-changer. Seizing conversion opportunities in low-earning years locks in favorable tax treatment and protects more of your nest egg from future taxation.
Performing Roth conversions during low-income periods (such as early retirement, business startup phases, or years in which you have large tax deductions) allows you to pay taxes at lower marginal rates, ultimately reducing future RMD obligations and enabling greater tax-free growth.
- Bracket Filling Conversions: Precisely convert amounts each year up to the limit of your current tax bracket.
- Market Dip Conversions: Converting traditional assets during market downturns can substantially boost tax-free growth potential.
- Life Event Conversions: Capitalize on lower-income years for larger Roth conversions, leveraging favorable tax conditions.
Withdrawal Sequencing in Practice
Consider a married couple in retirement filing jointly in 2024, aiming to stay within the 22% federal tax bracket, which applies to taxable income between approximately $94,301 and $201,050. Suppose they need $100,000 annually (This simplified calculation is based on the premise that the couple in question have no other income such as social security, pensions, etc.):
- Harvest up to $44,050 in long-term capital gains to raise cash for spending needs. This keeps their long-term gain bracket at 0%.
- Withdraw $50,000 from traditional IRAs to fill the 12% ordinary income bracket without exceeding the threshold for the 22% bracket.
- Tap into your Roth IRAs for any additional needs ($5,950 in this case), preserving most Roth assets for continued tax-free growth.
This approach limits taxes to $5,536 (a mere 5.54% effective rate) and places balanced pressure on all three accounts, bolstering the long-term health of your assets.
Bringing It All Together: Your Actionable Plan
While individual circumstances will vary, below are the general steps to consider when formulating a retirement withdrawal plan:
- Pre-Retirement Planning: Maintain thorough documentation (such as IRS Form 8606 for nondeductible IRA contributions, IRA contributions made throughout the years, etc.) and explore the option to initiate strategic Roth conversions early.
- Early Retirement (Pre-RMD Phase): Withdraw from taxable accounts, continue strategic Roth conversions, and delay traditional account withdrawals until necessary.
- RMD Phase: Meet mandatory RMD requirements, manage additional withdrawals to optimize tax brackets, and leverage Roth withdrawals for flexibility.
- Legacy Planning: Preserve Roth accounts as valuable, tax-free inheritances, providing heirs with a tax-efficient wealth transfer.
Conclusion
Crafting a tax-efficient withdrawal strategy requires thoughtful planning, ongoing adjustment, and clear understanding of nuanced rules like the Roth five-year period. Employing disciplined sequencing and strategic Roth conversions (where applicable) can help ensure that your retirement resources are optimized for minimal tax impact and maximal financial security.
For personalized assistance to craft a strategy tailored precisely to your circumstances and objectives, consider consulting a Certified Financial Planner™ (CFP ®) at AMM.