by Ross Langley and Craig Eissler
Here’s a question we often hear from clients who are either close to or enjoying retirement: Which account should I withdraw from first?
The answer, of course, depends on your unique finances. The conventional line of thinking suggests depleting taxable accounts first, while allowing tax-deferred and tax-exempt accounts to continue to grow and compound under their preferable tax status.
However, retirees frequently fail to consider more nuanced tactics that can potentially smooth their tax bill, potentially over decades of retirement.
Let’s start by considering the three types of accounts in terms of tax treatment:
- Tax-deferred: Retirement accounts like 401ks and traditional IRAs, whose assets will be taxed at normal tax rates upon withdrawal
- Taxable: Individual/joint accounts, non-retirement accounts
- Tax-exempt: Roth IRAs
Taking advantage of lower marginal tax rates
The flaw with depleting your taxable accounts first is that you might be foregoing an opportunity to pull money out of your tax-deferred accounts at very low marginal tax rates. Every retiree’s situation is different, but for many, the optimal path would be to fill lower marginal tax brackets with tax-deferred withdrawals, followed by pulling from taxable accounts—while preserving tax-exempt (Roth) assets for as long as possible.
Withdrawing funds from both taxable and tax-deferred accounts can help smooth taxes throughout your entire retirement.
Calculating your marginal tax bracket
Because distributions from tax-deferred accounts generate taxable income, if you itemize tax returns, you can capitalize on readily available deductions. These include mortgage interest, property taxes, charitable contributions, and medical expenses. These deductions can offset the income that should be considered when determining the next marginal tax bracket breakpoint.
If you’re still below the next-highest marginal tax bracket and comfortable with the cash generated, you might consider converting tax-deferred assets from your traditional IRA into a Roth IRA. This would generate taxable income on the conversion but, going forward, these Roth-harbored assets would grow tax-free. The point is to take advantage of a lower tax rate in one year, which would enable these assets to grow tax-free. Your distributions in later years would also be tax-free.