You worked, saved, and planned to enjoy the retirement life of your dreams. But those dreams cost money, and now you’re faced with choosing between various retirement withdrawal strategies . . . or have no strategy at all!

All things being equal—including taxes and investment performance—there’s no real benefit to various retirement withdrawal strategies. But in reality, things aren’t equal. Your pre-tax accounts distribute ordinary income. Your Roth IRAs are tax-free forever! And your taxable accounts have already been taxed.

Given the various tax consequences of different types of accounts, a tax-efficient retirement withdrawal strategy can add a substantial amount of money to your retirement planning with no additional risk. Similar to Morningstar’s “Withdrawal Sourcing” strategy, Vanguard believes a tax-efficient retirement withdrawal strategy has a massive impact—up to 1.1%—on a retired investor’s return.

1.1% per year is a huge amount of return for a spending strategy that has no additional risk!

In this article, I’ll explain how your retirement income strategy should work, and how you can use it to slash your lifetime taxes and keep more of your own money!

Different accounts are taxed differently

The reason there’s so much value in great retirement withdrawal strategies is that your accounts have different tax consequences. In fact, that very same reason is why asset LOcation is so powerful!

First, you must understand the tax implications of your savings and investment accounts. For example:

  • Pre-tax accounts like IRAs and 401(k)s (not including after-tax IRA contributions or Roth components) force income taxes on all distributions
  • Roth accounts and Roth 401(k)s are tax-free forever
  • Taxable accounts force a 1099 each year on the interest income, dividends, or capital gain distributions

Your retirement withdrawal strategy must take these tax implications into account or you’re simply donating massive amounts of money to the government each year! That’s money YOU should be enjoying during retirement!

Retirement withdrawal strategies

The goal is to have the most tax-efficient retirement withdrawal strategy. You can’t escape taxes altogether, but you can certainly minimize the amount you owe.

Ordering your withdrawals in the following manner should create a highly tax-efficient retirement withdrawal strategy:

  1. Required Minimum Distributions from IRA’s
  2. Cash flows (dividend and interest distributions) from taxable accounts
  3. Taxable accounts (selling and distributing assets which may have losses or smaller gains first)
  4. Tax-preferenced accounts
    1. If you expect a higher tax bracket in the future, draw from pre-tax IRA’s first then tax-free Roth accounts
    2. If you expect a lower tax bracket in the future, draw from tax-free Roth accounts first then pre-tax IRA’s

So for example, let’s assume you need $60,000 in retirement income this year and you’re 70 years old. Under the SECURE ACT, you don’t have any required minimum distributions from your IRA. Required minimum distributions start at age 72 now.

You have no RMDs, but you do have pre-tax IRAs in the amount of $300,000, taxable investment accounts to the tune of $300,000, and a tax-free Roth IRA in the amount of $200,000.

You are claiming Social Security now because you’re 70, and let’s assume that’s $30,000. You have a $30,000 retirement income shortfall.

Your taxable account is filled with a balanced portfolio of stocks and bonds which generates 2% in dividends and 2% in capital gains. You use that $12,000 of distributions to live on leaving you an $18,000 retirement income shortfall.

Now the decision becomes “Do I take the remaining $18,000 from my pre-tax IRA (generating a tax bill of $2,160 for married filing joint at the 12% marginal bracket) or take the $18,000 from the tax-free Roth IRA generating NO taxable income? Or, do I do some combination of both?

Assuming your tax rates will likely be higher in the future, you want to draw the $18,000 from the pre-tax IRA and pay the $2,160 in taxes owed from your taxable account.

Assuming your tax rates will likely be lower in the future, you’d be better off taking the $18,000 from the tax-free Roth IRA, leaving the pre-tax IRA to grow then liquidate later at lower tax rates than today.

What Vanguard missed . . . Roth Conversions

I’m a huge fan of Vanguard! They’re one of the best investment managers period. But . . . they missed the boat slightly! And when I say they “missed the boat” I simply mean they didn’t cover this incredibly important part of a long-term tax-efficient retirement withdrawal strategy.

In my example above they left some very low-hanging fruit on the table. What I mean by this is Roth conversions should be a huge part of your retirement withdrawal strategy for several reasons:

  • The “widow tax” penalty – When one spouse dies the widow is forced to draw income from an IRA at single taxpayer rates
  • Required minimum distributions can be massive – Your RMDs can be large enough to force you into higher marginal tax brackets, and while you may not need the entirety of that RMD income you’ll still be taxed on it then taxed again as the amount you didn’t need is invested into a taxable account
  • Paying more now can easily mean less later – Roth conversions force income taxes now and most people want to defer those taxes as long as humanly possible, but paying a bit more now can mean a lot less later
  • RMDs can force higher Medicare premiums – Medicare bases your premiums for Part B and Part D based on your modified adjusted gross income from two years prior and it’s not a sliding scale! If you go over by 1$ you’re forced into much higher premiums and you may be forced into higher Medicare premiums if you’re not reducing your future RMDs
  • Your heirs may suffer – If your non-spouse beneficiaries are high earners—or will be high earners—leaving them pre-tax accounts can really “whack them” financially because those funds must be drawn over 10 years after your death and if they’re already in a high marginal tax bracket this forced withdrawal can catapult them into higher brackets

For all of those reasons and more, if you have a taxable investment account you should absolutely consider converting your IRAs to Roth IRAs especially before you’re claiming Social Security and before being subject to IRA required minimum distributions. When done properly, Roth conversions have a massive impact—potentially far more than the 1.1% from your retirement withdrawal strategies—on the taxes you’ll pay during your retirement!

How a tax-efficient retirement withdrawal strategy adds up to 1.1%

1.1% per year is quite a lot of value-added for a strategy that has no risk to it! But how exactly does Vanguar place a 1.1% value on your retirement withdrawal strategy?

Here are the main assumptions:

  • A 50% stock and 50% bond allocation
  • 60% of the stocks are US based, 40% are foreign stocks
  • 70% of the bonds are US based, 30% are foreign bonds
  • 35 year time period
  • 39.6% marginal income tax rate
  • 20% long term capital gains rate

Vanguard calculated the IRR (internal rate of return) to the investor with two withdrawal strategies:

  • Tax-deferred assets (including Roth, IRA, 401(k), etc.) then taxable assets
  • Tax-free assets then taxable assets

What Vanguard found is accelerating distributions from tax-advantaged accounts in both cases reduced overall wealth.

Can everyone benefit 1.1% per year from this retirement withdrawal strategy?

The answer is no. This retirement withdrawal strategy has varying degrees of benefit depending on several factors. Most retirees however, can take advantage of it to some extent even if not the full 1.1% Vanguard states.

This all depends on the size of each type of account. The more evenly sized they are between taxable, pre-tax, and the tax-free Roth, the more you can manage the tax implications of your retirement income distributions.

Your tax bracket has a big impact on the value-added here as well. Most investors will realize some tax benefits, but if you’re in a higher tax bracket that’s where this strategy adds massive value!

Retirement withdrawal strategies in summary

If you don’t have a retirement income strategy, YOU’RE PAYING WAY TOO MUCH IN TAXES!

While this can be complex in practice—and your strategy will adjust yearly as your investments and life goals fluctuate—the tax savings are MASSIVE over your retirement!

Why is the value so big for retirees? Because you can slash your lifetime taxes plain and simple.

If you coordinate your retirement withdrawal strategy across all of your investment accounts and sources of income you’ll save taxes and improve your retirement plan results without any additional risk. This is as close to a “free lunch” as you’ll ever find when it comes to retirement planning!

Retirement withdrawal strategies frequently asked questions

What is a retirement withdrawal strategy?

A retirement withdrawal strategy is a method in which a retiree coordinates their cash flows, such as Social Security, interest payments, and dividends, with distributions from their savings and investment accounts. Several factors are taken into consideration when creating a retirement withdrawal strategy, such as required minimum distributions from IRAs, taxable income streams, and amounts invested in various types of accounts such as pre-tax, tax-free, and taxable, with the ultimate goal being to maximize your retirement income.

What is the most tax-efficient retirement withdrawal strategy?

According to a study done by Vanguard, the following retirement withdrawal strategy can add up to 1.1% to your retirement planning:

1. IRA Required Minimum Distributions
2. Other taxable distributions such as interest and dividend income
3. Taxable portfolio withdrawals
4. Distributions from pre-tax accounts (IRA/401k) if you believe your future tax rates will be higher OR distributions from tax-free Roth accounts if you believe your future tax rates will be lower than they are today

The overall monetary benefit of this retirement withdrawal strategy is determined by the types and balances of your accounts as well as your tax rate.

What is tax smoothing?

Tax smoothing is the process of using Roth conversions early in retirement to pay smaller controllable amounts of income tax in order to avoid larger income tax obligations—typically due to IRA required minimum distributions—later in life. The goal is to reduce your overall lifetime taxes.

What is the “widow tax”?

When one spouse dies the surviving widow loses the ability to pay taxes at the lower married filing jointly tax rates and is forced to pay income tax at the higher single filer rates.