Tax-Efficient Withdrawal Ordering in Retirement

The order in which you withdraw money from different account types can significantly affect your lifetime tax burden. With proper sequencing, you can keep more of your retirement savings working for you. This guide explains the general principles and when to deviate from conventional wisdom.

Understanding Account Types and Their Tax Treatment

Retirement savings typically fall into three categories, each with different tax characteristics:

Each account type has advantages and disadvantages depending on when you need the money and your tax situation at that time.

Capital Gains Tax Rates for Taxable Accounts

When you sell investments in taxable accounts, you pay capital gains tax on the appreciation. Long-term capital gains (assets held over one year) receive preferential rates:

2024 Long-Term Capital Gains Rates:

These thresholds are based on taxable income, including the capital gains themselves. Many retirees can harvest gains at 0% if their income is low enough.

Short-term capital gains (assets held one year or less) are taxed as ordinary income.

Tax-Deferred Account Withdrawals

Withdrawals from Traditional IRAs and 401(k)s are taxed as ordinary income. The tax rate depends on your total taxable income for the year.

2024 Ordinary Income Tax Brackets (Married Filing Jointly):

Large withdrawals from tax-deferred accounts push you into higher brackets and can trigger additional costs like IRMAA surcharges on Medicare premiums.

Roth Account Benefits

Qualified Roth withdrawals (account open 5+ years and owner age 59.5+) are completely tax-free. This includes both contributions and all investment growth.

Roth accounts also:

• Have no required minimum distributions during the owner's lifetime
• Pass to heirs who can take distributions tax-free
• Don't count toward MAGI for IRMAA calculations
• Don't affect Social Security taxation thresholds

The Conventional Withdrawal Sequence

The traditional advice is to withdraw from accounts in this order:

1. Taxable accounts first: Use these while allowing tax-advantaged accounts to continue growing
2. Tax-deferred accounts second: Tap these after taxable accounts are depleted
3. Roth accounts last: Let these grow tax-free as long as possible

This sequence makes sense because:

• Taxable accounts generate ongoing taxes whether you withdraw or not
• Tax-deferred accounts grow without annual taxation
• Roth accounts provide tax-free growth indefinitely

However, this simple approach ignores important nuances.

When to Deviate from the Conventional Sequence

Fill lower tax brackets from tax-deferred accounts:

If your income is unusually low in a given year, it may make sense to withdraw from your IRA to "fill up" lower tax brackets, even if you don't need the money for expenses. You can reinvest in a taxable account or Roth.

Harvest capital gains at 0%:

If your taxable income is below the 0% capital gains threshold, you can sell appreciated assets and pay no federal tax on the gains. This "resets" your cost basis higher.

Manage IRMAA and Social Security taxation:

Keeping income below certain thresholds can avoid Medicare premium surcharges and reduce taxation of Social Security benefits.

Required Minimum Distributions (RMDs)

Starting at age 73, you must take required minimum distributions from Traditional IRAs and most employer retirement plans. RMDs affect your withdrawal strategy because:

• You must take them regardless of whether you need the income
• They're taxed as ordinary income
• They can push you into higher tax brackets
• They affect IRMAA and Social Security taxation

RMD Calculation: RMD = Account balance as of December 31 prior year / Life expectancy factor

Sample RMD Factors:

As you age, the percentage you must withdraw increases, potentially pushing you into higher tax brackets.

Worked Example: Retiree with $500K Taxable, $800K IRA, $200K Roth

Patricia, age 66, is recently retired. Her husband passed away last year, so she files as single. She needs $70,000 per year for expenses and will receive $28,000 in Social Security.

Her portfolio:

• Taxable brokerage: $500,000 (cost basis $350,000)
• Traditional IRA: $800,000
• Roth IRA: $200,000

Approach 1: Conventional sequence (taxable first)

If Patricia sells $42,000 from her taxable account with a proportional gain, approximately $29,400 is gain (70% of withdrawal based on her cost basis ratio).

Her capital gains would be taxed at 0% (under the $47,025 threshold), and her Social Security would be partially taxable. Total federal tax: approximately $3,500.

Approach 2: Fill the 12% bracket from IRA

In this scenario, Patricia pays more tax this year (approximately $5,500). However, she:

• Reduces her future IRA balance and RMDs
• Keeps more in her taxable account (which gets a stepped-up basis at death)
• May avoid higher brackets later when RMDs begin

Approach 3: Roth conversion strategy

Patricia could take her $42,000 from taxable accounts plus convert $25,000 from her IRA to her Roth, staying within the 12% bracket.

She pays approximately $6,200 in federal tax but moves $25,000 to a tax-free account. If she's in the 22% bracket later, this saves $5,500 in future taxes.

Multi-year projection:

The Roth conversion strategy costs more initially but results in lower lifetime taxes, especially if Patricia lives into her 80s and 90s.

Coordinating with Social Security Taxation

Up to 85% of Social Security benefits can be taxable depending on your "combined income" (AGI + nontaxable interest + 50% of Social Security).

Social Security Taxation Thresholds:

Withdrawals from Roth accounts don't count toward combined income, making them valuable for managing Social Security taxation.

Year-by-Year Decision Framework

Checklist: Tax-Efficient Withdrawal Planning

• Calculate your expected Social Security benefit and taxation threshold
• Determine your taxable income from all sources (pensions, interest, dividends)
• Identify which tax bracket you'll be in before any retirement account withdrawals
• Calculate how much room you have in your current bracket before moving to the next
• Check if you can harvest capital gains at 0% (taxable income under threshold)
• Evaluate whether Roth conversions make sense before RMDs begin at 73
• Consider the impact of withdrawals on IRMAA (two-year lookback)
• Project your RMDs to see how they'll affect future tax brackets
• Review your cost basis in taxable accounts to estimate capital gains
• Model multiple withdrawal sequences over 5-10 years, not just one year
• Consider state income taxes, which may have different rules
• Consult a tax professional for complex situations or large accounts