Tax Considerations When Withdrawing from Investment Accounts

Written By: Brian Ellenbecker, CFP®, EA, CPWA®, CIMA®, CLTC®

Retirement is a key milestone in life to be celebrated. It is also a time of transition. For many, the uncertainty of replacing your paycheck can cause stress and anxiety. How do you create a retirement income strategy when there are so many potential sources, such as Social Security, retirement accounts, pensions, non-retirement investment accounts, annuities, and bank accounts, to name a few. Developing a retirement income strategy that not only provides the income you need but does so tax-efficiently for longevity is an essential financial planning step. Let’s explore tax-efficient ways to create a retirement income stream, focusing on your investment portfolio.

First, let’s look at how the different retirement account types are taxed:

Optimizing Your Withdrawal Strategy

Most people will need to supplement their fixed income sources like Social Security by withdrawing money from their investments. One way to make it easier is to consolidate all your investment accounts with the same investment company. Coordinating your withdrawal strategy, rebalancing accounts, and managing taxes all become easier when the assets are held at the same firm.

While your gut reaction might be to withdraw from only one type of account first, it’s likely that pulling from a combination of accounts will lead to the best tax result. You’ll want to consider the current year’s implications and your expected tax rates over the long term.

A general starting point is to consider pulling from traditional retirement accounts to fill the lowest ordinary brackets. Then consider pulling from your taxable accounts, realizing capital gains at a lower tax rate than ordinary income. If you have access to the 0% bracket, be sure to realize gains to fill up the entire 0% bracket, regardless of income needs. You can always reinvest it or hold it in cash if the funds are needed next year. Lastly, tap the Roth bucket for any funds that would otherwise force you to pay tax at a higher rate than you expect to pay over the long term if taken from another bucket. You can also use your Roth accounts to potentially avoid paying higher Medicare premiums or cause any other less-than-desirable tax results.

You will also want to consider the expenses you pay from each account. For example, if you are charitably inclined, consider donating with appreciated securities from your taxable account rather than using cash. You’d qualify for the same charitable deduction but also can avoid tax on the capital gain on the donated securities. If you’re over 70.5, consider using your Traditional IRA for charitable donations. Qualified Charitable Distributions can be taken from your IRA tax-free. Because the income is tax-free by rule, you don’t have to worry about qualifying for a charitable deduction by itemizing deductions. For medical expenses, including dental, vision, prescription drugs, etc., consider paying from a Health Savings Account (HSA) if you have one. Withdrawals for qualified medical expenses from HSAs are tax-free.

Once you reach a certain age, you will be required to take minimum distributions (RMDs) from your retirement accounts. The year distributions are required to start depends on the year you were born.

Once you reach your required distribution age, you may need to adjust your retirement income plan to account for the additional withdrawals required from your retirement accounts. You may also see an increase in your tax bill.

If you anticipate your RMD will be larger than what you need to spend that year, you may want to consider strategies for potentially reducing that distribution and the income tax you are forced to pay. Taking withdrawals from your retirement account before the RMD start age might help you spread the tax liability over a more extended period, potentially allowing you to pay tax at a lower rate. Doing so also reduces the balance in your retirement account, which will lower the required distribution amount. This strategy is particularly effective if you expect your tax liability to be lower from retirement until you’re required to start taking distributions. The most common strategy to implement is a Roth IRA Conversion.

Work with your tax advisor to help with your strategic tax planning for both the current year and the long term. The ultimate goal should be choosing a strategy that provides you with the income you need while keeping taxes and estate planning goals in mind. Making withdrawals from the proper account type each year can minimize your tax liability both now and in the future.