How to Strategically Spend Down Retirement Assets

Navigating retirement involves more than just saving; it requires a strategic approach to spending down accumulated assets. Understanding how to draw from various accounts can significantly impact financial longevity and overall tax efficiency. Thoughtful planning helps ensure retirement funds provide a stable income stream while minimizing tax liabilities. This process involves considering the characteristics of different account types and the rules governing their withdrawals.

Understanding Different Retirement Account Types

Retirement savings are held in various account types, each with distinct tax treatments for contributions and withdrawals. Understanding these differences is foundational for developing an effective spending strategy. The primary distinctions lie in whether contributions are made with pre-tax or after-tax dollars and how investment growth and eventual withdrawals are taxed.

Traditional retirement accounts, such as a 401(k) or Traditional IRA, allow contributions to be made on a pre-tax basis, which can reduce your taxable income. Investments within these accounts grow tax-deferred, meaning you do not pay taxes on earnings until you begin withdrawing funds in retirement. When withdrawals commence, they are taxed as ordinary income at your marginal tax rate.

Roth retirement accounts, including Roth 401(k)s and Roth IRAs, are funded with after-tax dollars, so contributions do not offer an immediate tax deduction. The benefit of these accounts is that both investment growth and qualified withdrawals in retirement are entirely tax-free. For withdrawals to be considered “qualified,” they must occur after age 59½ and after the account has been open for at least five years.

Many individuals also hold taxable brokerage accounts. Contributions are made with after-tax money. Investment gains, such as dividends and capital gains, are subject to taxation in the year they are earned or when investments are sold.

Navigating Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are mandatory annual withdrawals that the Internal Revenue Service (IRS) requires from most tax-deferred retirement accounts once the account owner reaches a certain age. The purpose of RMDs is to ensure that taxes are eventually paid on the tax-deferred savings. These rules apply to Traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k) plans, 403(b) plans, and 457(b) plans. Original owners of Roth IRAs are exempt from RMDs during their lifetime.

The age at which RMDs must begin has changed. For individuals who turn 73 in 2023 or later, RMDs start at age 73. The SECURE 2.0 Act further increases the RMD age to 75 for those who turn 74 after December 31, 2032.

The first RMD can be delayed until April 1 of the year following the year you reach the RMD age, but all subsequent RMDs must be taken by December 31 of each year. Delaying the first RMD means you would have to take two RMDs in the same calendar year, potentially pushing you into a higher tax bracket. The amount of your RMD is calculated by dividing your account balance as of December 31 of the previous year by a life expectancy factor provided by the IRS in their Uniform Lifetime Table.

Failing to take a full RMD by the deadline can result in a penalty. The IRS imposes an excise tax of 25% on the amount not withdrawn as required. This penalty can be reduced to 10% if the RMD shortfall is corrected. Account owners are responsible for ensuring they take the correct RMD amount each year. While RMDs apply to each individual account, RMDs for IRAs can be satisfied by taking the total required amount from any one or more of your Traditional IRA accounts. However, RMDs from 401(k)s must be taken from that specific 401(k) plan.

Developing a Strategic Withdrawal Order

Developing a strategic withdrawal order maximizes the longevity of retirement assets and optimizes tax efficiency. This involves understanding “tax diversification,” which refers to holding assets across different types of accounts: tax-deferred, tax-free, and taxable. A diversified approach allows for flexibility in choosing which accounts to draw from based on your annual income needs and the prevailing tax environment.

A common strategy involves prioritizing withdrawals from taxable brokerage accounts first. This approach allows tax-advantaged accounts, such as Traditional and Roth IRAs, more time for their investments to grow tax-deferred or tax-free. Capital gains from investments held in taxable accounts for more than one year are taxed at lower long-term capital gains rates compared to ordinary income rates. This can be beneficial, especially if these gains are your primary source of income early in retirement.

Strategic use of tax-deferred accounts, like Traditional IRAs and 401(k)s, comes next in a withdrawal strategy. Before RMDs begin, you have control over the timing and amount of withdrawals, which is advantageous for managing your tax bracket. You might consider withdrawing enough from these accounts to “fill up” lower tax brackets each year, converting otherwise tax-deferred income into taxable income at a low rate. This proactive approach can help reduce the balance subject to future RMDs and mitigate the impact of higher tax rates later in retirement.

Leveraging tax-free Roth accounts, such as Roth IRAs, is recommended later in retirement or during years when higher income from other sources would push you into a higher tax bracket. Because qualified Roth withdrawals are tax-free, they provide a source of income that does not increase your Adjusted Gross Income (AGI) or affect the taxation of other income sources, like Social Security benefits. Using Roth funds can be beneficial for managing your overall tax picture, especially when you are subject to RMDs from Traditional accounts.

Another consideration for optimizing your withdrawal strategy is performing Roth conversions. This involves moving pre-tax money from a Traditional IRA or 401(k) into a Roth IRA. While the converted amount is subject to income tax in the year of conversion, it can be a strategy if you anticipate being in a higher tax bracket in the future or want to reduce future RMDs from tax-deferred accounts. By converting funds during lower-income years, you can pay taxes at a lower rate now, allowing that money to grow and be withdrawn tax-free in retirement.

The optimal withdrawal strategy depends on your financial circumstances, projected income needs, and tax situation. It requires ongoing assessment and adjustment as tax laws change and your personal situation evolves.

Tax Implications of Retirement Withdrawals

The tax consequences of retirement withdrawals depend on the account type and the timing of the distribution. Understanding these implications is essential for effective financial planning in retirement. Different rules apply to traditional, Roth, and taxable accounts, and penalties can arise from early or insufficient withdrawals.

Withdrawals from Traditional IRAs and 401(k)s are taxed as ordinary income. The amount withdrawn is added to your other income for the year and taxed at your marginal income tax rate, similar to wages or salary. Since contributions to these accounts were made pre-tax, the entire withdrawal, including earnings, is subject to income tax.

For Roth accounts, the tax treatment of withdrawals distinguishes between qualified and non-qualified distributions. Qualified withdrawals from a Roth IRA are entirely tax-free and penalty-free. To be qualified, the withdrawal must occur after age 59½ and after a five-year waiting period. Non-qualified withdrawals can result in earnings being taxed as ordinary income and may also incur a 10% early withdrawal penalty. Contributions to a Roth IRA can always be withdrawn tax-free and penalty-free at any time, as they were made with after-tax dollars.

Withdrawing funds from most qualified retirement plans or IRAs before age 59½ incurs a 10% additional tax, in addition to regular income taxes. However, several exceptions can allow you to avoid this penalty. Common exceptions include withdrawals due to:

Permanent disability
Death of the account owner
Certain unreimbursed medical expenses exceeding a percentage of your adjusted gross income
Qualified higher education expenses
First-time home purchases
A series of substantially equal periodic payments (SEPPs)

The taxation of Social Security benefits is also influenced by other retirement income, including withdrawals from retirement accounts. A portion of your Social Security benefits may become taxable if your “combined income” exceeds certain thresholds. Combined income is calculated as your adjusted gross income, plus any non-taxable interest, and half of your Social Security benefits. For single filers, up to 50% of benefits may be taxed if combined income is between $25,000 and $34,000, and up to 85% if it exceeds $34,000. For those filing jointly, up to 50% of benefits may be taxed with combined income between $32,000 and $44,000, and up to 85% if it exceeds $44,000.

Withdrawals from taxable brokerage accounts are subject to different rules. Dividends received are taxed as ordinary income or, if they qualify, at lower capital gains rates. Capital gains, which are profits from selling investments, are taxed based on how long you held the asset. Short-term capital gains, from assets held for one year or less, are taxed at ordinary income rates, while long-term capital gains, from assets held for more than a year, benefit from lower tax rates. Unlike retirement accounts, there are no age-related penalties for withdrawals from taxable brokerage accounts.