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Paying Taxes Wisely: A Fresh Look at Tax-Efficient Withdrawal Strategies

Roger A. Young, CFP®, Senior Financial Planner, T. Rowe Price
Sometimes it pays to go against conventional wisdom. Here are two ways to possibly reduce taxes in retirement while extending the life of your nest egg by being smart about which accounts you tap first.

One of the challenges we face in retirement is finding the most advantageous way to draw down savings while minimizing taxes.

SEE ALSO: True or False: Test Yourself on Social Security Claiming Strategies

Many people have investments in a variety of accounts that have different tax characteristics. These can include traditional IRAs or 401(k)s, Roth IRAs and taxable brokerage accounts. In retirement, you'll probably need to withdraw money from these accounts to supplement your Social Security income.

The conventional wisdom is to withdraw from taxable accounts first; followed by tax-deferred accounts; and, finally, Roth assets. This approach affords your tax-advantaged accounts more time to grow tax-deferred -- but could also present you with more taxable income in some years than others. As your tax rate is dependent on your income, this could mean more taxes in those high-income years than you originally anticipated.

Federal income tax matters for retirees can be complicated. For example:

  • Withdrawals (distributions) from traditional, pretax IRA or 401(k) accounts are fully taxed as ordinary income.
  • Qualified distributions from a Roth account are tax-free.
  • For taxable accounts, interest received is ordinary income. However, if you sell investments, you only pay taxes on the gains (i.e., not invested principal, which is tax-free). Long-term capital gains and qualified dividend income are generally taxed at lower rates than ordinary income.

Everyone has different financial goals in retirement, but if you're concerned about outliving your assets, you might focus on extending the life of your portfolio, and/or increasing what you can spend in retirement. Here are two ways you can use tax savings to help achieve these goals.

1. Take full advantage of income subject to very low (or even zero) tax rates.

People with relatively modest incomes may think it best to follow the conventional model. After all, you may pay little or no taxes at first. However, once the taxable accounts are exhausted, you may end up paying a higher tax rate because you are generating more taxable income from tax-deferred account withdrawals.

Instead, consider using your low tax bracket strategically by consistently "filling up" that bracket with ordinary income from tax-deferred account distributions, such as your traditional IRA. If you need more than these withdrawals to support your lifestyle, you can sell taxable account investments, then take money from Roth accounts. This idea isn't new, but following the Tax Cuts and Jobs Act of 2017, more people may be able to limit their incomes to match their deductions -- thus paying zero taxes -- or stay within a low bracket.

As an example, assume a married couple:

  • Has $750,000 across their investment accounts: 60% tax-deferred, 30% Roth and 10% taxable;
  • Spends $65,000 (after taxes) each year; and
  • Collects $29,000 in Social Security benefits.

Using the approach described above they could completely avoid federal income taxes for 30 years and save $46,000 in taxes. This adds almost 2½ years to the life of their portfolio.

$750,000 portfolio; $65,000 annual spending in retirement
Conventional Wisdom Bracket-Filling Method
Account withdrawals (specific to this example) Taxable account (years 1-3); tax-deferred (years 3-18); Roth (years 18-30) Tax-deferred distributions $20,000-$23,000 each year; supplement with taxable account (years 1-5) and Roth (years 6-31)
Federal taxes paid over 30 years $46,000 $0
Longevity of portfolio with constant returns 29.2 years 31.6 years (8% improvement)

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