Avoiding the Pitfalls of Retirement Distribution Order

The order in which you take funds can have long-term tax consequences that directly affect how long your savings last. Many retirees underestimate this, focusing only on how much they withdraw rather than how they withdraw.
Your withdrawal strategy can make a significant difference in how much of your money you keep after taxes. By understanding some key principles of withdrawal sequencing, you can avoid common mistakes and stretch your retirement resources further.
A Framework for Smart Withdrawals
To maximize your after-tax retirement income, it’s important to understand how different accounts are taxed when you withdraw from them.
Broadly, there are three main types of investment accounts:
- Taxable accounts – Brokerage accounts funded with after-tax dollars. You’ll pay annual taxes on realized capital gains, interest, and dividends.
- Tax-deferred accounts – Includes traditional IRAs, 401(k)s, and 403(b)s. These are funded with pre-tax dollars and taxed as ordinary income when withdrawn.
- Tax-exempt accounts – Roth IRAs and Roth 401(k)s, funded with after-tax dollars. Qualified withdrawals are completely tax-free.
In most cases, the order in which you withdraw from these accounts has a big impact on your long-term tax liability. A common baseline strategy looks like this:
- Guaranteed income sources (Social Security, pensions) and Required Minimum Distributions (RMDs)
- Taxable accounts
- Tax-deferred accounts
- Tax-exempt (Roth) accounts
This approach allows tax-advantaged accounts to stay invested longer, potentially increasing after-tax wealth over time. However, this should be viewed as a starting point rather than a rigid rule.
Issues to Consider in Withdrawal Sequencing
Some important exceptions and nuances can make the baseline sequence less than optimal. Among the most important are legacy planning, Roth conversions, and tax management.
Legacy Planning
Leaving taxable accounts untouched may provide heirs with a valuable benefit. When taxable assets are inherited, their cost basis is generally “stepped up” to the market value at the date of death. This can eliminate years of unrealized capital gains taxes, making taxable accounts powerful tools for efficiently passing on wealth to heirs.
Roth Conversions
Roth conversions involve moving funds from a tax-deferred account (like a traditional IRA) into a Roth account. You’ll pay taxes on the converted amount, but from that point forward, the money grows and is distributed tax-free. Conversions are especially appealing in low-income years, when you can move funds at a lower tax rate. When paired with charitable giving strategies, it’s possible to offset some of the conversion-related tax impact.
Tax Management Beyond the Basics
Several other tax considerations can influence the best withdrawal sequence. One is the Social Security “tax torpedo,” where additional income can cause more of your Social Security benefits to become taxable. Another is Medicare premium surcharges (IRMAA), which increase costs if your income crosses certain thresholds. Retirees should also account for the so-called “widow’s penalty,” when a surviving spouse moves into single filer brackets that may result in higher taxes on the same income. Finally, Qualified Charitable Distributions (QCDs) from IRAs can be a powerful way to reduce taxable income while meeting charitable goals.
Planning for Your Needs
How you withdraw assets from your accounts can reduce your lifetime tax bill, extend portfolio longevity, and better align with both lifestyle and legacy goals. But the optimal sequence depends on your income sources, tax bracket, health, and long-term objectives. For most retirees, the best strategy blends withdrawals across different account types to smooth out tax exposure rather than following a rigid order.
Within the context of retirement planning, it’s not just about how much you’ve saved; it’s about how much you keep after taxes. While the basic rules are straightforward, the nuances can be complex, and the stakes are high. That’s why it’s important to work with a financial advisor or tax professional to tailor a strategy to your personal goals and income needs.
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