A tax-smart way to tap retirement funds

By John Carruthers
Posted on September 15, 2022

You work hard for decades and save diligently for retirement, but unfortunately, you can’t retire from paying taxes.

An important part of enjoying a fruitful retirement is understanding how taxes apply to different types of income and planning accordingly. Having sizable amounts of money in various accounts is wonderful, but taxes can eat away at them quickly if you don’t have a sound tax strategy heading into retirement.

And sadly, many people don’t. One survey found that 42% of current retirees reported they did not consider how taxes would impact their retirement income.

Don’t get caught off guard and let taxes adversely affect your golden years. One of the keys to developing a good tax strategy for retirement is understanding the order of withdrawals you should follow.

Knowing when and how to draw on your various assets can have a big impact on how much in taxes you’ll owe from year to year.

Take from taxable accounts first

Non-qualified or taxable accounts — those that are not tax-advantaged — include checking and savings accounts, standard or joint brokerage accounts, and employer stock purchase plans. Taxable brokerage accounts are your least tax-efficient accounts, subject to capital gains and dividend taxes.

By using these funds first in retirement, you give your tax-advantaged accounts (IRA, Roth IRA) more time to grow and compound. Brokerage accounts will never grow as quickly as tax-advantaged accounts because they are subject to the annual drag of taxation on interest, dividends and capital gains.

Use tax-deferred accounts next

Here we’re talking about the traditional IRA, 401(k) and 403(b), all of which are subject to ordinary income tax rates when you withdraw money from them.

One reason you withdraw from tax-deferred accounts second is that you’ll know roughly what tax rates are going to be in the short term. Those rates are relatively low now; the 2017 Tax Cuts and Jobs Act expires at the end of 2025.

From a tax perspective, it doesn’t matter whether you start withdrawing first from a traditional IRA or 401(k), but keep in mind that required minimum distributions (RMDs) for both accounts begin in the year you turn age 72 (or 70½ if you reached that age before Jan. 1, 2020).

Roth IRA or 401(k) comes last

A prudent retirement income and tax strategy maximizes tax-advantaged growth while maintaining the flexibility of funding some portion of your retirement expenses with non-taxable income. It’s doable due to a Roth conversion strategy, in which you convert portions of tax-deferred accounts to a Roth account.

Money in Roth IRAs or Roth 401(k)s is not taxable income when you withdraw from them as long as you follow the rules, meaning account holders must be 59½ or older and have held the account for at least five years.

Withdrawals are tax-free for your heirs, regardless of their age, if the original account was opened at least five years before.

The idea for the account holder is to let it sit and grow tax-free as long as possible before tapping into it. (There is no RMD for a Roth IRA account holder, although there is one for the Roth 401(k) and those inheriting Roths.)

The IRS requires any Roth conversion to have occurred at least five years before you access the money; otherwise, you may be charged taxes or penalties for withdrawals.

When you convert a traditional IRA or 401(k) to a Roth IRA, you’ll owe income taxes at your ordinary tax rate for that year on the amount you converted. But to many people, it’s worth it on the back end.

There is no limit on the amount you can convert in a given year, but it usually makes sense to execute the conversion over several years in order to lessen the tax hit. Converting a large amount in one year might push you into a higher tax bracket.

When doing Roth conversions, it’s important to consider what the funds will be invested in after you convert them. And given the growth potential in a Roth, it’s wise to start making some annual Roth conversions from tax-deferred accounts during your buildup years toward retirement — the earlier, the better.

The bottom line

By planning ahead with a sound strategy, you could minimize your taxes in retirement and increase your financial security.

After spending so many years working and focusing on saving and investing, you owe it to yourself to investigate various tax scenarios that await in retirement and to consult a qualified financial adviser to help you devise a plan.

Dan Dunkin contributed to this article.