As our clients approach retirement, the conversation flips from asset accumulation to income distribution, and this change involves new complexities. One of the most important parts of a successful retirement plan is preparing a tax-efficient income withdrawal strategy. This strategy isn’t just about guaranteeing income; it’s about preserving wealth over the client’s lifetime by minimizing their income taxes. A good withdrawal plan can impact the longevity of retirement savings and the total taxes the client pays over their lifetime.Before beginning any withdrawal strategy, we must first understand the entire position of the client’s income tax situation. This includes identifying all sources of retirement income, such as Social Security, pensions, annuities, rental income, and investment returns. Equally as important is to review the client’s account types; these accounts normally consist of a mix of taxable brokerage accounts, tax-deferred accounts like traditional IRAs and 401(k)s, and tax-free accounts such as Roth IRAs. Knowing how the income from each of these accounts is taxed, both at the federal and state levels, forms the foundation for any effective withdrawal strategy.
One approach many planners use involves taking advantage of tax diversification across different account types. Instead of relying on a single source of income in retirement, a blend of withdrawals from taxable, tax-deferred, and tax-free accounts can improve the chances of staying within lower tax brackets, lowering taxable income in high-income years, and increasing long-term tax efficiency. The sequence and proportion of withdrawals from each account should be customized annually to the client’s often changing income needs, tax situation, and personal financial goals.
Previous traditional client advising followed this basic withdrawal sequence: drawing from taxable accounts, then from tax-deferred accounts, and finally from Roth accounts. This strategy offers some benefits, such as letting tax-advantaged accounts grow. However, it often fails to consider future tax liabilities. However, a more strategic approach focuses on managing marginal tax brackets over time. For example, taking small, consistent withdrawals from a traditional IRA in early retirement, even before required minimum distributions (RMDs) begin, can help smooth taxable income and prevent clients from being pushed into higher brackets later on.
The early years of retirement, especially between the start of retirement and age 73, when RMDs begin, present a valuable opportunity for Roth IRA conversions. Converting portions of a traditional IRA to a Roth IRA allows the client to pay taxes at today’s potentially lower rates, while shifting funds into a tax-free vehicle that will not be subject to RMDs. This window can be one of the most tax-efficient periods in a client’s life. Careful planning is vital, however, to ensure that conversions don’t accidentally cause higher taxes or phaseouts for deductions and tax credits.
Managing capital gains is another area of potential income tax efficiency. In years when a client’s taxable income is relatively low, long-term capital gains can fall into the 0% federal tax rate. Financial planners can use this opportunity to harvest gains from appreciated assets, increase basis, and reallocate investments, without creating a taxable event. Contrarily, recognizing capital losses can offset gains and reduce the overall tax burden during higher-income years. The flexibility of capital gains planning, especially when combined with Roth conversion strategies and careful income layering, makes it a basis of tax-efficient retirement income planning.
In summary, creating a tax-efficient withdrawal strategy is one of the most valuable services a financial planner can provide. The right approach can increase after-tax income, minimize total tax burden, and help clients preserve their wealth throughout retirement. Strategies such as mixing account withdrawals, using Roth conversions during low-income years, and managing capital gains can all contribute to a smarter, more resilient retirement income plan. By proactively addressing tax implications in the withdrawal phase, planners deliver both financial clarity and peace of mind for their clients.
The material discussed in this article is meant as general information and should not be taken as legal advice.
Rick Hedderick, MBA, CFP, is an Associate Teaching Professor of Finance and the Certificate in Financial Planning Program Director at Penn State Behrend, Sam and Irene Black School of Business.
Editor: Greg Filbeck, CFA, FRM, CAIA, CIPM, PRM, Samuel P. Black III, Professor of Finance & Risk Management, Penn State Erie, mgf11@psu.edu.