Pay Fewer Taxes on Your Retirement Income With This Withdrawal Strategy

Looking to pay fewer taxes on your hard-earned retirement income and extend the life of your savings? Doing so may be easier and simpler than you expected.

For retirees with assets from taxable investment accounts to Roth IRAs, Fidelity recommends a proportional withdrawal approach that relies on all of your accounts at the start of retirement. Rather than withdrawing assets from one account at a time, Fidelity found that proportionally withdrawing money from each of your accounts simultaneously can reduce the taxes you pay throughout retirement which extends the lifespan of your savings ¹ .

A financial advisor can help you withdraw your retirement assets in a tax-efficient manner and provide other retirement advice.

This Common Withdrawal Strategy May Be Costing You

As Fidelity notes, tax professionals often recommend withdrawing assets from taxable accounts first, followed by tax-deferred accounts like traditional 401(k)s and IRAs then Roth IRAs. This strategy allows your Roth assets to continue to grow tax free, since Roth IRAs are not subject to required minimum distributions.

But this approach of withdrawing assets from one account at a time can result in what Fidelity calls a “tax bump” in the middle of retirement.

As an example, say you’re a retiree with $200,000 in a taxable brokerage account, $250,000 in a traditional 401(k) and $50,000 in a Roth IRA. And let’s say you must generate $60,000 worth of after-tax retirement income to meet your spending needs. You collect $25,000 in annual Social Security benefits, and as a result, must withdraw approximately $35,000 from his various accounts.

If you withdraw assets from one account at a time, starting with taxable investment accounts, you’ll largely avoid taxes through the first seven years of retirement. That’s because your income will be low enough that you won’t pay long-term capital gains taxes on withdrawals from your brokerage account. But that won’t last.

After exhausting the assets in your brokerage account, say you begin drawing down your traditional 401(k) accounts. However, you must pay income taxes on these withdrawals. As a result, you’ll pay approximately $66,000 in income taxes over the next 12 years of retirement, according to Fidelity’s analysis. At this pace, your traditional 401(k)s would be tapped out halfway through your 19th year of retirement. From there, your Roth IRA assets would last you about four more years.

Proportional Withdrawals: A Tax-Savvy Alternative

Fidelity says you have a more tax-efficient alternative. Taking withdrawals from all three sources spreads out your tax liability and slightly extends the life of the portfolio by one year.

Following this approach, you would withdraw approximately $15,000 per year from your taxable account for the first 23 years of retirement. At the same time, you would withdraw around $18,000 from your traditional 401(k) each year, while also supplementing those withdrawals with another $4,000 from your Roth IRA.

While this strategy would result in paying taxes practically every year, it would dramatically reduce your tax liability compared to the more traditional withdrawal strategy. Instead of paying an estimated $65,988 in taxes during the middle portion of retirement, Fidelity found you would pay just $41,398 in estimated taxes throughout retirement. That’s a 37% reduction! 

How to Implement a Proportional Withdrawal Strategy

Setting up a proportional withdrawal strategy involves taking consistent percentages from each type of account, rather than depleting one source before moving on to the next. This is not the only retirement withdrawal strategy but, if you think it works for you, here’s what you’d need to do: 

1. Calculate Your Account Proportions: You would start by determining the total value of all your retirement accounts and assign a percentage to each.. For example, if you have $500,000 total, with $200,000 in taxable accounts, $250,000 in traditional 401(k)s and $50,000 in Roth IRAs, your respective proportions are 40%, 50% and 10%.
   
2. Withdraw Based on Those Percentages: Each time you take a withdrawal,you could  take the same percentage from each account. If you need $50,000 for the year, you’d withdraw $20,000 from your taxable account, $25,000 from your traditional 401(k) and $5,000 from your Roth IRA.
   
3. Use Tools to Automate or Track Withdrawals: Many financial institutions and custodians offer automated withdrawal tools or calculators that can maintain your desired proportions. Platforms like Fidelity’s Retirement Income Planner, Vanguard’s withdrawal calculators or SmartAsset’s planning tools, like our retirement and RMD calculators, can help estimate the most tax-efficient mix for your situation.
   
4. Rebalance Annually: Over time, investment performance will cause each account’s balance to shift. Revisit your withdrawal proportions each year to ensure they still align with your original percentages. Rebalancing keeps your strategy aligned with both your investment goals and tax efficiency.

Run the numbers with our income tax calculator to see how different withdrawal strategies and asset locations can affect your tax bill year by year.

Tax Implications by Account Type

Knowing how each account type is taxed can help you manage your total tax bill in retirement. Different withdrawal sources are taxed in different ways, which is why proportional withdrawals can help you smooth your tax liability over time.

• Taxable Accounts: Withdrawals from brokerage accounts can trigger capital gains taxes. Long-term capital gains (on assets held for more than a year) are generally taxed at 0%, 15%, or 20% depending on your income level. Dividends may also be taxed, though qualified dividends often receive favorable rates.
  
• Traditional IRAs and 401(k)s: Withdrawals are taxed as ordinary income since contributions were made pre-tax. The exact rate depends on your tax bracket at the time of withdrawal. These accounts are also subject to required minimum distributions (RMDs) starting at age 73.
  
• Roth IRAs: Qualified withdrawals, meaning you’re over 59 ½ and the account has been open for at least five years, are tax-free. Because Roth IRAs aren’t subject to RMDs during your lifetime, they can be strategically used to control taxes and preserve assets for later years or heirs.

Here’s a simplified example comparing after-tax outcomes from $50,000 in withdrawals:

Note: Rates are illustrative and depend on your individual income, deductions, and state tax laws.

Bottom Line

For retirees with assets spread across multiple accounts, including taxable brokerage accounts, traditional 401(k)s and Roth IRAs, Fidelity found that a proportional withdrawal strategy can limit your tax liability and make your retirement savings go further. This approach relies on making withdrawals from each of your accounts simultaneously based on that account’s percentage of your overall savings. A financial advisor can provide additional insights into the best tax and retirement strategies for your budget. 

Retirement Planning Tips

• Planning for retirement can be complicated and overwhelming. A financial advisor can help you make important financial decisions related to your retirement plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Tracking your progress toward reaching a savings goal is critical. SmartAsset’s Retirement Calculator can help you estimate how much you’ll have in savings when the time comes to retire and getting a better sense of where you stand.

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