The distribution phase of retirement can be significantly more complex than the accumulation phase leading up to it. In the accumulation phase, you are contributing to accounts and buying investments. In the distribution phase, you are selling investments and distributing money from accounts. The latter two events typically trigger taxes which adds an additional layer of complexity to your finances.

Most retirees have more than one account type: a brokerage account (Taxable), a 401k/IRA (Tax-deferred), and/or a Roth IRA (Tax-free). Each of these accounts are taxed differently. Managing the sequence of withdrawals from different accounts can significantly reduce the amount of tax you pay over your lifetime. Every investor’s situation is different but optimizing your withdrawal strategy can create the opportunity to spend more, gift more or pass more on to your beneficiaries.

In one study, the most tax efficient withdrawal strategy extended the longevity of the financial portfolio by 7.5 years more than the least tax efficient strategy (Reichenstein, William. “Retire Right: The Critical Importance of Tax Efficient Withdrawal Strategies to Portfolio Longevity”, Page 3).

We typically see two types of withdrawal strategies with investors. The pro rata and the sequential withdrawal strategy (Defined below).

Pro Rata Withdrawal Strategy - This strategy is withdrawing what you need for expenses proportionally from the three different account types - Taxable (Bank and brokerage), Tax-deferred (IRA and 401k) and Tax-free (Roth IRA and Roth 401k).

Sequential Withdrawal Strategy - This strategy is withdrawing what you need for expenses from taxable accounts first. Once those accounts are depleted, withdrawing from tax-deferred and then finally tax-free accounts.

The case study below is used to illustrate the difference in results between the two withdrawal strategies.

Case Study – John and Jill Smith

John and Jill: Married

Current ages: 59/59

Target retirement age: 66/66

Salary: $150,000/ $150,000

Social Security: 70/70

Monthly expenses in retirement: $10,000

Invested assets: $2.0mm 401k & IRAs

$250,000 Bank & Brokerage Accounts

The Smiths have a 93% probability of success for funding their goals until age 96. Since their retirement funding looks good, now we want to evaluate which withdrawal strategy provides the most tax adjusted wealth. Tax adjusted wealth is the portfolio value at the end of the plan but adjusted for the taxes that would be owed on the tax-deferred accounts. This takes into consideration that income taxes are not owed on Roth IRA distributions but are owed on Traditional IRA distributions. For example, $1 million in a Roth IRA is more valuable than $1 million in a Traditional IRA due to the taxes that will be owed on the Traditional IRA.

The graph below shows the tax adjusted wealth for each withdrawal strategy. The sequential withdrawal strategy is on the left and the pro rata withdrawal strategy is on the right.

The sequential strategy provides approximately $930k more in tax adjusted wealth than the pro rata strategy. This is an increase of over 11%. This doesn’t involve taking more risk with your investments. It is simply optimizing the order in which you withdraw from taxable, tax-deferred, and tax-free accounts.

How to Reduce Taxes Further

Implementing the sequential withdrawal strategy is a great first step. There are other tax planning strategies that can also be implemented to further reduce taxes. The graph below illustrates the Smith’s taxable income from various sources until age 96. Take note that the “withdrawal from tax deferred” (Orange) continues to grow substantially throughout retirement. This is because the required minimum distributions (RMDs) force the Smiths to withdraw a percentage from their 401ks and IRAs each year. As they age, the RMD percentage increases, forcing them to withdraw larger amounts of money. This has the potential to force them into a higher tax bracket later in retirement. This presents some opportunities as well as concerns.

Our “Tax Planning in Retirement” ebook goes into more detail about how to implement strategies to take advantage of these opportunities and avoid these concerns. You can download the ebook by subscribing to our monthly newsletter below. Most people believe you should always defer taxes, but the truth is you should pay taxes when you are presented with opportunities to pay a lower rate.