The Most Tax-Efficient Way to Take Money Out of Your Retirement Accounts, LFG Daily
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The Most Tax-Efficient Way to Take Money Out of Your Retirement Accounts
Most people spend decades focused on one question:
How much money do I need to retire?
But once retirement arrives, a potentially more important question emerges:
Which account should I take the money from first?
If you have a combination of Roth accounts, Traditional IRAs, 401(k)s, and non-qualified investment accounts, the order in which you withdraw your money can have a major impact on how much you ultimately pay in taxes.
Two retirees can have the exact same net worth and spend the exact same amount of money every year—but one may pay significantly more in taxes simply because they withdrew their money in a less efficient order.
That is why retirement income planning is not just about investment returns.
It is also about tax-efficient distribution strategies.
The Three Buckets of Retirement Money
For simplicity, most retirees have money in three different types of accounts:
1. Roth Accounts
Roth IRAs and Roth 401(k)s are generally funded with money that has already been taxed.
The benefit is that qualified withdrawals are generally tax-free. Roth accounts also do not have required minimum distributions during the original owner’s lifetime under current law.
This makes Roth money extremely valuable.
2. Traditional IRAs and 401(k)s
Traditional retirement accounts typically provide a tax deduction when money goes in, but withdrawals are generally taxed as ordinary income.
Eventually, required minimum distributions force you to take money out, whether you need it or not.
This is often the largest future tax liability many retirees own.
3. Non-Qualified Accounts
These include taxable brokerage accounts and other investments held outside retirement accounts.
The taxation can vary. You may have dividends, interest, short-term capital gains, and long-term capital gains.
The key advantage is that you typically have more control over how much taxable income you realize each year.
That control can be extremely valuable.
The Common Strategy: Spend Taxable Money First
A traditional rule of thumb is:
Spend taxable accounts.
Then spend Traditional IRAs.
Save Roth accounts for last.
At first glance, this makes sense.
Why spend money that is growing tax-free when you can spend money that is already taxable?
But retirement planning is rarely that simple.
If you spend all of your non-qualified money first, you may create a large Traditional IRA balance that eventually produces massive required minimum distributions.
You could end up deferring taxes for years—only to create a much larger tax problem later.
The Better Strategy: Manage Your Tax Bracket
The goal should not necessarily be to avoid taxes today.
The goal should be to pay the right amount of taxes at the right time.
For example, imagine someone retires at age 62.
They have:
$1 million in a Traditional IRA
$500,000 in a taxable investment account
$300,000 in a Roth IRA
Social Security beginning later in retirement
They may have several years before required minimum distributions begin.
Those years could represent a valuable tax-planning opportunity.
Rather than simply withdrawing money from the taxable account and allowing the Traditional IRA to continue growing untouched, the retiree might consider:
Taking some money from the Traditional IRA
Converting some money to a Roth IRA
Using taxable investments to supplement spending
Managing capital gains to stay within favorable tax brackets
The goal is to intentionally fill lower tax brackets today rather than potentially being forced into higher tax brackets later.
The Retirement “Tax Window”
One of the most valuable periods for tax planning often occurs after someone retires but before required minimum distributions begin.
Your income may temporarily fall.
You may no longer have a salary.
You may not yet be collecting Social Security.
You may not yet be required to take large distributions from your IRA.
This can create a temporary period where your taxable income is significantly lower than it was during your working years.
That is the window.
During this period, it may make sense to intentionally recognize income through:
Traditional IRA withdrawals
Roth conversions
Realizing long-term capital gains
Exercising certain stock options
Selling highly appreciated investments
The goal is to use lower tax brackets before future income sources begin stacking on top of each other.
Why Roth Conversions Can Be So Powerful
Suppose you have $1 million in a Traditional IRA.
You may not need the money today.
But that does not mean it is tax-free.
Eventually, distributions may be required. And every dollar distributed from a Traditional IRA is generally included in taxable income.
A Roth conversion allows you to voluntarily move money from a Traditional IRA into a Roth IRA.
You pay taxes on the amount converted today, but future qualified withdrawals from the Roth IRA can generally be tax-free.
The key is timing.
Converting too much could push you into unnecessarily high tax brackets.
Converting too little could leave you with a large future tax liability.
The right amount depends on your overall financial plan.
The question is not:
“Should I do a Roth conversion?”
The better question is:
“How much should I convert this year?”
The Role of Non-Qualified Money
Taxable investment accounts are often treated as the least desirable retirement asset because they are not tax-deferred or tax-free.
But they can provide something incredibly valuable:
Flexibility.
You can often choose:
Which investments to sell
How much to sell
When to sell
Which tax lots to sell
Whether to realize gains or losses
That flexibility allows you to coordinate taxable account withdrawals with IRA distributions and Roth conversions.
For example, a retiree might use:
Taxable money to pay living expenses
Traditional IRA money to fill a lower tax bracket
Roth conversions to move money into the tax-free bucket
This is much more sophisticated than simply withdrawing from one account until it reaches zero.
Roth Accounts Are More Than Just Retirement Accounts
Roth accounts are often viewed as the last account you should spend.
That can be a good strategy—but not always.
Roth money can serve as a valuable reserve for:
Large unexpected expenses
Major purchases
Healthcare costs
Market downturns
Years when your taxable income is already high
Legacy planning
Because Roth withdrawals can generally be tax-free, Roth assets may be more valuable than their account balance suggests.
A $100,000 Roth IRA is not the same as a $100,000 Traditional IRA.
The Traditional IRA may create future tax liabilities.
The Roth IRA generally does not.
This is why your financial plan should focus on after-tax wealth, not simply the number displayed on your investment statement.
The Best Strategy Is Usually a Combination
For many retirees, the most tax-efficient strategy may look something like this:
Step 1: Determine Your Annual Spending Need
How much money do you actually need to live?
Not how much can you withdraw.
How much do you need?
Step 2: Calculate Your Other Income
Include:
Social Security
Pensions
Rental income
Business income
Annuities
Interest
Dividends
Step 3: Identify Your Tax Bracket
How much additional income can you recognize before moving into the next tax bracket?
This helps determine whether Traditional IRA withdrawals or Roth conversions make sense.
Step 4: Coordinate Your Accounts
Instead of automatically taking money from one account, consider a combination of:
Taxable account withdrawals
Traditional IRA distributions
Roth conversions
Roth withdrawals when appropriate
Step 5: Consider Future Taxes
What happens when:
Social Security begins?
Required minimum distributions begin?
Your spouse dies?
Your tax filing status changes from married filing jointly to single?
Your investments appreciate?
Tax laws change?
The most tax-efficient strategy today may not be the most tax-efficient strategy over the next 20 or 30 years.
The Widow’s Tax Trap
One of the most overlooked retirement tax risks is the death of a spouse.
A married couple may currently file taxes jointly.
After one spouse dies, the surviving spouse may file as a single taxpayer.
The surviving spouse could have:
One less personal exemption or deduction structure
The same or similar income
Potentially higher tax rates
Continued IRA distributions
Social Security income
Required minimum distributions
In other words, the surviving spouse may have less income but a larger tax burden.
This is another reason why proactive tax planning during both spouses’ lifetimes can be so important.
The Goal Is Not to Die With the Most Money in Your Roth IRA
Many people say:
“I want to leave my Roth IRA to my children and spend everything else first.”
There may be situations where that makes sense.
But the goal of financial planning should not necessarily be to die with the largest possible Roth IRA.
The goal is to maximize your lifetime financial security, flexibility, and legacy—after taxes.
Sometimes that means preserving Roth money.
Sometimes it means using Roth money.
The right answer depends on:
Your spending needs
Your tax bracket
Your health and longevity expectations
Your other assets
Your charitable intentions
Your heirs
Future tax law
The type of assets you own
The Bottom Line
Retirement is not the end of financial planning.
In many ways, it is when financial planning becomes most important.
Accumulation is relatively simple:
Save money. Invest money. Grow money.
Distribution is more complicated:
Which account should you use? How much should you take? What tax bracket should you target? Should you convert money to Roth? Should you realize capital gains? What happens when RMDs begin? What happens if your spouse dies?
The best retirement distribution strategy is rarely:
“Take money from this account first, then that account, then the next one.”
It is usually a coordinated, year-by-year strategy designed to manage taxes over your entire retirement—not just minimize taxes this year.
Because the goal is not simply to have money.
The goal is to maximize the amount of money you can actually spend, enjoy, and ultimately pass on after taxes.
**Your retirement account balance is not your true wealth.
Your after-tax financial plan is.**
Click here to schedule a meeting — I’m here to help you take the next step toward financial freedom.
Colin Symons, CIO Lloyd Financial Group
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S&P PMI and New Home Sales, today.
Bottom line: Markets are seeing some reversion after a decent beating, yesterday.
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