A critical part of an overall financial plan, regardless of age, is having goals for how you will live and spend in the short and long term and managing the assets you have accumulated to fund those goals.
Drawing down those assets in a tax-efficient way after retirement can have a significant effect on the plan.
“In retirement, your mindset shifts from earning to how to draw down from the different account buckets you have accumulated over your working life that have different asset characteristics and tax effects,” said Robert Westley, CPA/PFS, senior vice president and regional wealth adviser at Northern Trust Corp. in New York City. “It is a puzzle, but getting it right makes a big difference over the course of retirement in how to stretch out the funds and extract the most you can on an after-tax basis.”
Common mistakes retirees make in withdrawing funds from their accounts include not having a diversified portfolio that can withstand market downturns, spending too much so that the portfolio declines or runs out, and not planning for withdrawals such as required minimum distributions (RMDs).
KEY FACTORS TO CONSIDER WHEN PLANNING A DRAWDOWN STRATEGY
Retirees need to consider the size and composition of their investment portfolio and their ability to manage market volatility over time; whether they have pensions or life insurance; how and where they want to live in retirement; and the timing, amounts, and types of taxes they will have to pay as they draw down their assets. They may also need to consider how their drawdown decisions affect assets they plan to leave to heirs and the tax implications.
“Part of the overall planning process is a cash flow analysis that includes retirement goals, such as travel and gifting, how to draw from investments to fund the spending, and the likely tax brackets you will be in during retirement,” said Erin Itkoe, CPA/PFS, president and wealth adviser at Luminescent Wealth Management Inc. in Scottsdale, Ariz.
For CPA financial planners, managing clients’ life savings so they don’t run out of money is a huge responsibility, because everybody has different perspectives on how they want to live in retirement, said Marianela Collado, CPA/PFS, senior wealth adviser and CEO of Tobias Financial Advisors in Fort Lauderdale, Fla. “I recommend planning to age 100, rather than to life expectancy.”
HOW TAX-EFFICIENT DRAWDOWN STRATEGIES IMPACT SAVINGS
The goal is to maximize retirees’ tax brackets over one’s lifetime, to avoid going from low to high brackets because of insufficient planning. “Retirees should pay attention to their tax brackets and how much they will have to draw to first fill up the lower brackets to smooth out income,” Itkoe said.
But there is no one-size-fits-all withdrawal strategy, and drawdowns must be tailored for each retiree’s situation, Westley said.
Certain withdrawals are mandatory, including pensions or RMDs. If retirees are in a low tax bracket, they may prefer to take distributions from tax-deferred IRAs, but if they are in a high bracket, they may favor using Roth accounts.
The impact of tax-efficient drawdowns is best illustrated using financial models. A long-range retirement projection reflects not only the probability that retirees will meet their goals through the end of their plan, but also future estimated income tax brackets, and the values of taxable, tax-deferred, and tax-free accounts annually and, more importantly, at the end of the plan, Collado said.
The analysis would look at the impact of drawing down qualified accounts before RMDs are required, to take advantage of lower brackets, which would help avoid much higher brackets in the future due to larger RMDs. The most impact will be seen when those accelerated drawdowns are moved over to a Roth IRA, so the future growth is tax-free.
Take a 55-year-old who is currently earning $100,000 per year, is planning to retire at 62, and has already accumulated $2.5 million, including a 401(k) with a balance of $125,000, Collado said.
In scenario A, where distributions from the taxable account supplement expected retirement income, RMDs would kick in at age 75 and take the client into a higher, 24% tax bracket that same year. Looking beyond 75, the higher RMDs and projected portfolio income would push them into higher tax brackets more frequently (see the full scenario A in PDF format).
Scenario B implements a laddered Roth conversion strategy, which accelerates withdrawals from qualified accounts right after retirement at 62, when the salary drops off but before the RMDs kick in. That maximizes the 22% tax bracket for four years. The result is a lifetime savings of $124,144. Projected out to age 100, the value of the entire portfolio is $15,657,042 under scenario B, compared with $14,991,251 under scenario A — a $655,791 difference (see the full scenario B in PDF format).
Generally, tax alpha is very hard to capture and quantify, Collado said. The laddered Roth conversion strategy increases portfolio return by 0.6% over the life of the portfolio by shifting $1,885,658 to the Roth.
THE IMPACT OF RMDs ON A RETIREE’S TAX STRATEGY
Most people who have employer-sponsored retirement plans (401(k), 403(b), and simplified employee pension (SEP) plans) and traditional IRAs are required to take distributions annually beginning with the calendar year they reach age 73. The distribution must be made no later than April 1 of the following calendar year for the first year and Dec. 31 in subsequent years.
Effective Jan. 1, 2033, the SECURE 2.0 Act (Division T of the Consolidated Appropriations Act, 2023, P.L. 117-328) raised the starting age for RMDs to 75 for those born in 1960 or later. They have the option to take their first RMD in the year they turn 73 (or 75) but can also delay that first-year RMD to April 1 of the following year. If they delay, they will have to take the second RMD by Dec. 31 the same year.
“I would run a two-year, side-by-side comparison of taking an RMD in each year vs. delaying and doubling up in year two, because it may not always be advantageous to delay that first-year RMD,” Collado said.
The IRS provides a table of factors, based on age, that changes annually. Penalties apply when the full amount of the RMD is not withdrawn by the due date.
“Account custodians must provide a notice to IRA holders each year that either calculates or offers to calculate the RMD based on the year-end market value of the accounts. Account custodians also must inform the IRS on Form 5498 that an RMD is required from the account,” Itkoe said. “Form 1099-R is filed for each person who has received any type of distribution, and the IRS cross-references those amounts to amounts that should have been taken.”
HOW TO WITHDRAW TO MINIMIZE TAXES
The general rule when deciding how to withdraw is to try to take advantage of lower tax brackets to minimize taxes due on distributions.
“The order depends on whether you have mandatory withdrawals and what tax bracket you are going to be in,” Westley said. “It is best to preserve tax-deferred and Roth accounts that can grow tax-free. If you are already in a high tax bracket, you may want to withdraw from a Roth account. If you are in a low tax bracket, you may want to withdraw from tax-deferred accounts, like traditional IRAs, until you are at a tax bracket when it no longer makes sense for you to pay taxes at that rate and then use a Roth account.”
Also, consider cash flow needs for the year, Itkoe said. “Generally, the plan should be drawing from accounts subject to RMDs, like IRAs, first if you are required to take RMDs; then taxable accounts (because realized capital gains from assets held at least a year are generally taxed at a better tax rate than ordinary income); and then tax-free accounts. If you have heirs you plan to pass assets to, tax-free assets may be the best ones to have left.”
THE BENEFITS OF ROTH CONVERSIONS
A Roth account is a good option if an investor expects to be in a higher tax bracket in future retirement years, when withdrawals are planned. Roth 401(k) and Roth 403(b) plans are subject to RMDs, but a simple planning strategy is to roll them over to a Roth IRA. Then the RMDs are avoided, as Roth IRAs are not subject to RMDs, Westley said.
“When converting a traditional tax-deferred IRA to a Roth, you pay ordinary income taxes on the fair market value of the converted amount upfront, and then earnings grow tax-free,” he said. “A good time to convert may be in the years immediately after retirement, when they may have a few years of low taxable income because Social Security benefits have not started and RMDs are not required. Retirees should look at what tax bracket they are in based on their other taxable income and consider a Roth conversion, filling up the lower tax brackets for the difference.”
Also, the SECURE Act (Setting Every Community Up for Retirement Enhancement Act of 2019, Division O of the Further Consolidated Appropriations Act, 2020, P.L. 116-94) eliminated age restrictions for making contributions to traditional IRAs, allowing those who are 70 and over to continue making IRA contributions. Those can then be moved into a Roth, where assets can grow tax-free if you have earned income, including from a part-time job, Collado said.
PLANNING FOR LARGE, ONE-OFF EXPENSES
Retirees should consider their tax bracket when deciding where to get the funds to cover one-off expenses, Itkoe said.
“Is there room in the lowest tax brackets to fill them up with taxable income from distributions this year rather than put them in a higher tax bracket next year?” she added. “If not, maybe they can take a tax-free Roth distribution. Or for short-term needs, clients may borrow against their portfolio on margin for a few months rather than take a distribution that will affect their taxes.”
Collado recommends that her clients have an emergency savings account, in cash or money market accounts, to cover the unexpected, like an emergency roof replacement or a car breaking down. “With an emergency fund, if a one-off expense happens at a point the market is down, portfolio assets will not have to be sold; if the portfolio yields better-than-projected returns, it may be possible to absorb the unexpected expenses,” she said.
DRAWDOWN STRATEGIES FOR HEALTH CARE COSTS
Retirees under age 65 who are not eligible for Medicare may have to get private health insurance, and they may have to draw from assets to fund the costs. At lower adjusted gross income levels, higher tax credits are available on premiums for policies under the Affordable Care Act, Westley said.
“If you have an HSA [health savings account], you can withdraw amounts tax-free to pay health insurance premiums,” he said. (See “How Medicare Rules Affect HSA Eligibility After Age 65,” JofA, Feb. 1, 2025.)
Once a client is eligible for Medicare, income levels affect their Medicare bracket and premiums. Part B and D Medicare premiums are based on modified adjusted gross income (MAGI).
“The government looks back to two years’ prior tax returns to determine whether your income exceeds threshold amounts, and, if so, there will be an income-related surcharge to the Part B and D Medicare premiums,” Itkoe said.
Medicare benefits can be expensive for retirees whose income, including RMDs, put them in a higher Medicare bracket — as high as $600 per month for life, Collado said. Planning early and timing a Roth conversion properly may facilitate getting rid of the IRA before an RMD is required and avoiding the monthly income-related premium adjustment amount for the rest of the retiree’s life, because distributions from Roth accounts do not count toward MAGI. A warning, however: Roth conversions do count towards MAGI.
MANAGING THE TAX IMPACT OF SOCIAL SECURITY BENEFITS
Social Security benefits are taxed at different thresholds based on filing status and “combined income,” which includes AGI, nontaxable interest, and half of Social Security income.
If clients work during retirement, depending on their age, their income can affect Social Security benefits and income taxes. If they are younger than “full retirement age” and earn more than the yearly earnings limit, there is a $1 deduction in benefits for every $2 earned above the annual limit. In the year clients reach full retirement age, their benefits will be reduced by $1 for every $3 they earn above an income threshold ($62,160 for 2025). If they are above full retirement age, there is no benefit reduction for income. For taxpayers who are married filing jointly whose combined income is $32,000 or less, their benefits are not taxable. If their combined income is $32,001 to $44,000, their benefits may be taxable up to 50%. For those whose combined income exceeds $44,000, benefits may be taxed at 85%.
Some retirees rely on Social Security benefits and may start collecting them earlier, compared with others who have pensions or other assets. “If you can defer when you start collecting closer to full retirement age, you will collect a higher amount,” Westley said. “You also may have lower income-tax years by pushing off the Social Security, which can be a good strategy.” He notes that if a retiree decides to work part time after retirement or join a board of directors, it may increase taxable income and affect Social Security benefits and should be included in the retirement drawdown model.
Itkoe recommends that in deciding when to take benefits, retirees should consider other income sources to smooth out income and manage tax brackets.
“The key to all these strategies is thinking about all of them proactively because there is nothing more powerful than considering the impact of your choices today when you are in your 40s, rather than when you are in your 60s, when all these things will come at you,” Collado said. “This includes your portfolio, being thoughtful of where you are saving, and using Roth accounts. If you are not managing your portfolio in a tax-efficient way both before and in retirement, there will be negative implications for Social Security and Medicare premiums. Everything affects something else.”
About the author
Maria L. Murphy, CPA, is a freelance writer based in North Carolina. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.
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