Retirement is your time to unwind, travel, and spend time with loved ones—not worry about surprise taxes cutting into your savings. But the reality is, without a solid plan, taxes can take a bigger bite out of your retirement funds than you might expect.
The bright side?
With smart strategies, you can reduce your tax bill and hold on to more of your hard-earned money. By understanding how different retirement accounts are taxed and creating a withdrawal plan tailored to your needs, you’ll set yourself up for golden years that are just that—golden!
Understanding How Retirement Account Withdrawals Are Taxed
When it comes to taxes, accounts used for retirement vary wildly. The type of account you’re pulling money from—and when you decide to do it—has a major impact on how much of your savings ends up with you versus the IRS.
Let’s look at the most common accounts withdrawn from for retirement:
Traditional Retirement Accounts: With a Traditional IRA or Traditional 401(k), you get a tax break on the front end by contributing pre-tax dollars, which reduces your taxable income during your working years. But here’s the trade-off: when you start withdrawing, the funds are taxed at ordinary income tax rates. These accounts are also subject to required minimum distributions (RMDs), which will require you to make withdrawals at a certain age.
Roth Accounts: A Roth IRA or Roth 401(k) flips the script. You pay taxes upfront when you contribute, but withdrawals are entirely tax-free if you’re at least 59½ and meet the five-year rule. Even better, Roth IRAs don’t come with RMDs, so you can leave the funds untouched for longer—or even pass them down as a tax-free inheritance.
Taxable Accounts: Taxable brokerage or savings accounts add another layer of options. While you’ll owe taxes on dividends, interest, and short-term gains (which are taxed like regular income), long-term investments held for over a year are taxed at long-term capital gains rates, which are typically much lower.
The Impact of Timing on Tax Efficiency
When you withdraw from your retirement accounts plays a major role in your tax planning. The right timing can end up saving you tons, but poor timing could mean paying far more than your fair share.
Here’s how timing factors in:
Early Withdrawal Penalties: Taking money out of a traditional retirement account before age 59½ often comes with a steep price: a 10% early withdrawal penalty plus taxes. The same penalties and taxes may apply to Roth accounts on any earnings distributed prematurely.1 There are exceptions for things like medical expenses or buying your first home, but relying on these funds too early can hurt your long-term savings.
Required Minimum Distributions (RMDs): After you turn 73, the IRS requires distributions to start coming out of your traditional retirement accounts (i.e., your required minimum distributions, or RMDs). These withdrawals count as taxable income, which can increase your tax bill significantly. Delaying your first RMD until the following year could mean taking two RMDs in one tax year, bumping you into a higher income tax rate bracket.
Withdrawals Made Before Age 73: In the years leading up to RMDs, taking smaller withdrawals can help you manage your tax liability. If your taxable income is lower early in retirement, you can withdraw enough to stay in a lower tax bracket. This not only covers your financial needs but also reduces the size of future RMDs, keeping your tax burden lighter over the long haul.
Proportional vs. Sequential Withdrawals
How you choose to withdraw funds from your retirement accounts also plays a major role in how much money you get to keep. Your approach affects your taxes, cash flow, and financial flexibility.
Two common strategies—sequential withdrawals and proportional withdrawals—offer different benefits depending on your situation.
Sequential withdrawals prioritize taxable accounts first, then move to tax-deferred accounts, and finally, Roth accounts. By starting with taxable funds, you can minimize early taxes using lower rates like long-term capital gains while allowing tax-deferred accounts to grow.
The downside?
Delaying tax-deferred withdrawals may lead to larger RMDs later, potentially increasing your tax bracket when mandatory withdrawals begin.
Now let’s talk about proportional withdrawals…
Proportional withdrawals spread distributions across taxable, tax-deferred, and Roth accounts at the same time. This strategy helps balance taxable income annually, preventing steep tax increases when RMDs start up. It also provides greater flexibility in managing both your finances and tax obligations, keeping the overall tax hits predictable and manageable.
Okay, but which option is better for you?
Sequential withdrawals are often better for retirees with modest early retirement income who want to maximize the growth of tax-deferred accounts. Proportional withdrawals work well for retirees with higher balances in tax-deferred accounts or those seeking consistent, predictable tax outcomes.
Leveraging Roth Conversions
A Roth IRA conversion provides another avenue for taking charge of your retirement income. By paying taxes upfront on the funds you convert, you reap the benefits of tax-free growth and withdrawals later, making it a powerful tool for managing your income.
Is there a best time to make these conversions?
If your income is lower in retirement—especially in the years between stopping work and the start of Required Minimum Distributions (RMDs) or Social Security benefits—you may be in a lower income tax rate bracket. This makes it an ideal time to convert portions of your traditional retirement account savings into Roth IRA savings without triggering a large tax bill.
Another factor to keep in mind is that Roth conversions also shrink the balance of your tax-deferred accounts, which leads to smaller RMDs later. This can help you keep your taxable income lower in your 70s and beyond, minimizing the chance of your Social Security benefits being taxed at higher levels.
Please Note: While Roth conversions can be a savvy tax strategy, converting too much in one year could move you into a higher tax bracket. Spreading conversions over several years can help manage the tax implications and ensure you make the most of this opportunity.
Charitable Giving as a Tax Strategy
Giving to causes you care about doesn’t just feel good—it can also help you manage your taxes in retirement. With a little planning, your charitable donations can fit seamlessly into your financial strategy, reducing your tax liability while supporting the organizations that matter to you.
Here are some ways to make it work:
Qualified Charitable Distributions (QCDs): If you’re 70½ or older, you can transfer up to a specified amount each year directly from a Traditional IRA to a qualified charity. QCDs can also count toward your Required Minimum Distributions (RMDs), but they aren’t included in your taxable income. This makes them an excellent way to lower your tax bill while giving back to the community.
Charitable Trusts: For those who want to make a larger impact, a charitable trust—such as a Charitable Remainder Trust—can provide a steady income stream for you or your beneficiaries during retirement. At the end of the trust’s term, the remaining funds go to the charity of your choice. These trusts allow you to make a meaningful difference in the world while giving you an upfront tax deduction for the value of your donation.
Combining Charitable Contributions with Other Strategies: Charitable giving doesn’t have to stand alone—it can complement other smart tax strategies to maximize your benefits. For instance, donating highly appreciated investments allows you to avoid paying capital gains taxes while supporting a cause you care about. Similarly, pairing a qualified charitable distribution (QCD) with a Roth conversion in the same year can help lower your taxable income, giving you a dual advantage: reduced taxes and support for a greater cause.
Using Tax-Loss Harvesting and Capital Gains Strategies
Taxes don’t have to hold back your investment growth. With strategies like tax-loss harvesting and capital gains planning, you can lighten your tax burden while keeping your portfolio on track. The right moves can make all the difference for your retirement income.
What exactly is tax-loss harvesting?
Tax-loss harvesting is a strategy that can transform underperforming stocks into tax savings. The process works by selling stocks at a loss to offset the gains in other areas of your portfolio.
Even if your losses exceed your gains, you can deduct up to $3,000 annually from your ordinary income tax rates and carry forward any excess losses to future years.2 This approach is particularly helpful if you’re withdrawing from taxable accounts during retirement.
That said, remember that timing matters a lot when it comes to capital gains.
Investments held for over a year qualify for long-term capital gains tax rates. These are generally lower than the rates for regular income. In some cases, you might pay 0% on these gains if your income falls below specific thresholds. By carefully timing your sales to stay within favorable tax brackets, you can fund your retirement with minimal effects.
The right coordination with account withdrawals can amplify saving further…
Let’s say you’re withdrawing from a Traditional IRA to cover expenses. If you harvest losses from your taxable accounts at the same time, you can offset the taxes owed on your withdrawal, keeping your overall taxable income lower. By coordinating withdrawals and sales, you stretch your retirement dollars further while reducing your overall tax load.
Managing Social Security Taxation While Taking Withdrawals
Social Security benefits are an important part of retirement income for many people, but they’re not always tax-free. The amount of other income you bring in can determine whether most of your benefits end up being taxed or not.
Understanding Provisional Income and Taxability
The IRS looks at something called “provisional income” to figure out if your Social Security benefits will be taxed. This includes half of your benefits plus other income like withdrawals from a Traditional IRA, wages, or even interest from tax-exempt bonds.
If your provisional income exceeds specific thresholds, up to 50% of your benefits may become taxable. At even higher income levels, as much as 85% could be taxed.3 By understanding where your income falls on this scale, you can plan withdrawals from your retirement accounts more effectively and reduce the tax implications.
Minimizing the “Tax Torpedo” with Roth Withdrawals
The “tax torpedo” is what happens when extra income—like withdrawals from a Traditional IRA—ends up increasing how much of your Social Security benefits are taxed. This can cause your overall tax bill to spike unexpectedly.
Similar to that 50% to 85% jump we were just talking about…
This is where a Roth IRA comes in handy. Since Roth IRA withdrawals are tax-free, they don’t count as provisional income. By relying on Roth withdrawals instead of taxable accounts, you can avoid increasing your provisional income—and keep more of your Social Security benefits tax-free.
Delaying Benefits for Higher Payouts and Lower Taxes
Delaying your Social Security benefits past “full retirement age” (that’s 67 years old if you were born in 1960 or later) can really pay off. For each year you hold out, your monthly check can increase by 8%, depending on your birth year.4 This strategy not only boosts your future income but also creates a window in early retirement to draw down tax-deferred accounts while your income tax rate is lower.
By combining delayed Social Security with strategic withdrawals, you can spread out your taxable income over several years, keeping your overall taxes lower. That means higher Social Security payments later and less stress about taxes.
Tax Implications of Withdrawals Made by Beneficiaries of Your Retirement Account(s)
Passing on your retirement savings is a meaningful way to support loved ones, but it’s important to plan ahead for tax purposes. Different types of retirement accounts come with very different rules for beneficiaries, and the choices you make now can have a big impact on their financial future.
Here’s how it breaks down:
Traditional vs. Roth Accounts for Inheritance: Leaving a traditional or Roth retirement account to your heirs will require them to withdraw all funds within ten years. With traditional accounts, heirs pay taxes at ordinary income tax rates, which could increase their tax burden or even their tax bracket. In contrast, a Roth IRA allows heirs to make tax-free withdrawals, preserving the account’s full value—a significant benefit for both you and your loved ones.
Roth Conversions to Reduce Heirs’ Tax Burden: Converting part of your traditional retirement savings to a Roth IRA during your lifetime can ease the tax load for your beneficiaries. You’ll pay taxes on the conversion now, allowing the withdrawals to remain tax-free for them later. Converting during low-income years can help you minimize upfront taxes and create a more efficient inheritance.
Stretch IRA Opportunities for Certain Heirs: Some beneficiaries—like minor children, disabled dependents, or a surviving spouse—may qualify for an extended withdrawal period beyond the ten-year rule.5 Assigning accounts to these eligible heirs strategically can reduce immediate tax burdens and maximize the long-term value of your gift.
Charitable Giving for Tax Savings: You may also want to consider naming a charity as the beneficiary of your Traditional IRA. Charities don’t pay taxes on inherited accounts, meaning 100% of your gift supports your cause.
Additional Strategies to Minimize Taxes in Retirement
Managing taxes in retirement isn’t just about withdrawals and timing—it’s also about using a mix of strategies to ensure your savings go further.
Here are some other smart, actionable steps to consider:
Consolidate Retirement Accounts: If you have multiple accounts, such as old 401(k)s, rolling them into a single IRA can simplify your finances, reduce fees, and make managing investments easier. If you’re still working, funds in your current employer’s plan may also let you delay RMDs, giving you better control over your taxable income.
Consider Loans From Retirement Accounts: Borrowing from a 401(k) might not be your first choice, but it can be an option for short-term needs. Unlike regular withdrawals, loans from retirement accounts don’t count as taxable income if you repay them on time. Be cautious, though—if you fail to repay your loan, it may result in taxes and penalties.
Invest in Tax-Preferred Assets: For investments outside of retirement accounts, consider tax-advantaged options like municipal bonds. Interest from these bonds is typically exempt from federal taxes and, in some cases, state taxes too. Adding tax-preferred assets to your portfolio can generate tax-efficient income while keeping your overall tax burden low.
Our Team Knows How to Pay Less Tax on Retirement Account Withdrawals
Taxes in retirement can eat away at all your hard work, but you don’t have to fend them off alone. Whether you’re wondering how to handle Required Minimum Distributions (RMDs), considering a Roth conversion, or weighing the pros and cons of different withdrawal strategies, our team is here to guide you.
We specialize in creating personalized strategies that minimize your tax burden while helping you meet your retirement income goals. From managing ordinary income tax rates to crafting tax-efficient legacy plans, we’ll help you protect your savings and achieve the financial freedom you deserve.
Let us take the stress of retirement tax planning off your shoulders. We invite you to schedule an introductory call today! Together, we can start building a strategic tax plan that keeps more of your money in your pocket—and your future secure.
Sources:
- https://www.investopedia.com/ask/answers/082515/how-do-you-calculate-penalties-ira-or-roth-ira-early-withdrawal.asp
- https://www.irs.gov/taxtopics/tc409
- https://www-origin.ssa.gov/benefits/retirement/planner/taxes.html
- https://www.ssa.gov/benefits/retirement/planner/delayret.html
- https://www.schwab.com/ira/inherited-and-custodial-ira/inherited-ira-withdrawal-rules
Sheena is a highly regarded financial professional known for her clear explanations and practical advice on complex financial matters. She earned her CERTIFIED FINANCIAL PLANNER™️ designation in 2010 and holds a Bachelor of Science degree in Finance from the University of Wisconsin LaCrosse.
