What Is the Best Order of Withdrawal in Retirement?

The sequence in which you access different retirement accounts, known as the order of withdrawal, can influence how long your money lasts and the total taxes you pay. A well-designed withdrawal plan is a strategic exercise in managing income and tax liability to support your lifestyle after you stop working. The effectiveness of a retirement income strategy hinges on understanding the tax implications of each savings vehicle. The goal is to generate the necessary cash flow while minimizing the portion lost to taxes each year.

Understanding Your Retirement Accounts by Tax Treatment

Retirement savings are organized into three categories based on their federal tax treatment: taxable, tax-deferred, and tax-free. Each type has distinct rules for contributions, growth, and withdrawals. Understanding these differences is fundamental to building an effective retirement income plan.

Taxable Accounts

Taxable accounts include standard brokerage and savings accounts funded with after-tax dollars. The earnings, such as interest, dividends, and capital gains, are taxed annually as they are realized. When you withdraw money, your original contribution is returned tax-free, but any appreciation is subject to capital gains tax. Assets held for more than one year are taxed at lower long-term capital gains rates, while assets held for a year or less are taxed at higher ordinary income tax rates.

Tax-Deferred Accounts

This category includes traditional 401(k)s, 403(b)s, and traditional IRAs. Contributions are often made on a pre-tax basis, providing an immediate tax deduction and lowering your current taxable income. The investments grow tax-deferred, meaning you do not pay taxes on the earnings annually. The trade-off is that all withdrawals in retirement, including contributions and growth, are taxed as ordinary income at your prevailing marginal tax rate.

Tax-Free Accounts

Tax-free accounts include Roth IRAs and Roth 401(k)s. Contributions are made with after-tax dollars, so there is no upfront tax deduction. The money grows completely tax-free, and qualified withdrawals in retirement are not subject to income tax. To be qualified, Roth withdrawals must occur after you reach age 59½ and have held the account for at least five years.

The Conventional Withdrawal Hierarchy

The most widely recognized approach to sequencing retirement withdrawals follows a three-step order. This framework aims to minimize taxes over the long term by allowing tax-advantaged accounts to grow untouched for as long as possible.

Step 1: Taxable Accounts First

This strategy begins with drawing down assets from taxable brokerage accounts. This allows your tax-deferred and tax-free accounts to continue compounding without being diminished by withdrawals or taxes. Only the investment gains are subject to tax, often at long-term capital gains rates that are lower than ordinary income tax rates. For some retirees in lower income brackets, the long-term capital gains rate may even be 0%.

Step 2: Tax-Deferred Accounts Second

After taxable accounts are depleted, the next step is to take withdrawals from tax-deferred accounts like traditional IRAs and 401(k)s. The goal is to postpone this step for as long as possible to maximize the period of tax-deferred growth. Delaying these withdrawals allows earnings to accumulate without being reduced by annual taxes.

Step 3: Tax-Free Accounts Last

The final step is to tap into tax-free Roth accounts. Preserving these accounts is beneficial because they offer tax-free growth and withdrawals, providing income that does not increase your tax liability. Roth accounts are not subject to Required Minimum Distributions (RMDs) for the original owner, offering greater flexibility. They also serve as a tax-efficient asset to pass on to heirs.

Alternative Withdrawal Strategies

The conventional hierarchy is not optimal for every retiree. Alternative strategies offer more flexibility to address specific financial situations, such as managing tax brackets or smoothing out tax liability over retirement. These methods require a more hands-on approach but can lead to better outcomes in certain circumstances.

Pro-Rata Strategy

The pro-rata strategy involves taking a proportional percentage of your needed income from each account type every year. For example, if 50% of your savings are in tax-deferred accounts, you would draw 50% of your annual income from them. This method contrasts with depleting one account type before moving to the next. The goal is to smooth out your tax liability over your lifetime, creating a more consistent annual tax bill and avoiding a “tax bump” in later years.

Dynamic or Tax-Bracket-Focused Strategy

A dynamic, or tax-bracket-focused, strategy is an active approach that adjusts to your annual tax situation. A retiree might intentionally withdraw funds from tax-deferred accounts only up to a certain threshold, such as the top of a low federal income tax bracket. This tactic “fills up” lower tax brackets with income taxed at a favorable rate. The purpose is to realize taxable income in low-income years to reduce the balance in tax-deferred accounts, which lowers future RMDs that could push you into a higher tax bracket.

Integrating Social Security and Required Minimum Distributions

A withdrawal plan must account for Social Security benefits and Required Minimum Distributions (RMDs). These factors are governed by federal rules that influence when you must access your personal savings and can override a previously established strategy.

Social Security Timing

The age you claim Social Security impacts how much income you must generate from your portfolio. You can claim as early as age 62 for a reduced payment, at your full retirement age (around 67) for your standard payment, or delay until age 70 for an increased payment. Delaying Social Security requires you to withdraw more from your accounts in early retirement to cover expenses. Taking benefits early reduces the immediate strain on your portfolio but provides less guaranteed income later in life.

Required Minimum Distributions (RMDs)

Federal law requires you to take withdrawals from tax-deferred retirement accounts like traditional IRAs and 401(k)s. The starting age for these Required Minimum Distributions (RMDs) is 73 for those born between 1951 and 1959, and 75 for those born in 1960 or later. The first RMD must be taken by April 1 of the year after you reach your RMD age, with subsequent RMDs due by December 31 each year. Failure to take the full RMD can result in a penalty of 25% of the shortfall, which can be reduced to 10% if corrected in a timely manner. These mandatory withdrawals can disrupt a withdrawal strategy, as you must take the RMD from your tax-deferred account regardless of your preference.

Developing a Personalized Withdrawal Plan

The optimal order of withdrawal is not a one-size-fits-all solution. The best plan is tailored to your unique financial circumstances and goals, which involves assessing several factors.

Assess Income Needs vs. Wants

Create a detailed retirement budget that distinguishes between essential living expenses (needs) and discretionary spending (wants). This helps establish your baseline income requirements and shows how much of your spending is flexible. In years with poor investment returns, you can cut back on discretionary spending to reduce withdrawals and preserve your portfolio.

Consider Future Tax Rates

Your expectation for future tax rates should influence your strategy. If you anticipate being in a higher tax bracket later in retirement, perhaps due to large RMDs, it may be wise to pay some taxes now at a lower rate. This can be done by withdrawing from tax-deferred accounts or through Roth conversions. If you expect your future tax rate to be lower, deferring taxes may be more advantageous.

Factor in Legacy Goals

Your desire to leave an inheritance is an important consideration. If a tax-efficient legacy is a priority, your strategy should focus on preserving certain accounts. Roth IRAs are often the most valuable asset to pass to heirs because beneficiaries can withdraw the funds tax-free. Defining your legacy goals helps determine which accounts to spend and which to preserve.

Health and Longevity Expectations

Your health and life expectancy play a role in your withdrawal plan. A longer life expectancy increases the risk of outliving your assets and facing higher healthcare costs. This may favor strategies that preserve tax-free accounts, like Roth IRAs, for later in life. The decision of when to claim Social Security is also heavily influenced by longevity expectations.