5-Step Tax-Smart Retirement Income Plan

If you're 73 or older, required minimum distributions (RMDs) should be your first stop when tapping your retirement portfolio to avoid paying up to a 25% penalty for withdrawing late or not at all. (Most financial institutions can help calculate your RMDs when the time comes.)

Whatever you withdraw will be taxed as ordinary income, so if you don't need this money to cover your living expenses, consider depositing the funds into a taxable brokerage account, where it could potentially continue to grow.

Next, withdraw the interest and dividends from your taxable accounts while maintaining your original investment, which can then potentially grow and continue generating income in the future. (Be sure to consider turning off automatic reinvestment of interest and dividends on your bond and stock funds, CDs, and individual stocks.)

That said, interest is taxed as ordinary income—unless it's from a tax-free municipal bond or municipal bond fund. Dividends, on the other hand, are often taxed at the lower capital gains rate of 0%, 15%, or 20%, depending on income level—provided certain requirements, such as minimum holding periods, are met.

Many retirees rely on bonds and certificates of deposit (CDs) to generate regular income. Laddering such investments—that is, buying bonds and/or CDs with staggered maturity dates and reinvesting the principal as each comes due—can help provide a steady stream of income from interest payments while evening out your portfolio's yields over time.

However, should you still need cash after exhausting RMDs (if you're of age) and your interest and dividends, the principal from a maturing bond or CD is often the next place to turn. Instead of reinvesting the principal, consider using that cash to fund your living expenses. This can be very tax-efficient since you generally won't owe taxes on the principal returned to you. Generally, you'll want to hold on to the bond or CD until its maturity date to avoid triggering potential capital gains taxes on any earnings from selling early.

The next major source of income is to sell additional investment assets, such as stocks or mutual funds, in the most tax-efficient way possible. But which accounts should you tap first—and in what proportion?

If you have modest tax-deferred savings and your RMDs aren't likely to push you into a higher tax bracket later in retirement, it may be a good time to turn to your taxable brokerage accounts.

First, consider selling investments that have lost value. Selling at a loss allows you to use all the funds for living expenses because you'll owe no taxes. Also, by using a strategy known as tax-loss harvesting, you can offset any capital gains with your capital losses and, if your losses exceed your gains, up to $3,000 of ordinary income with the remainder.

Just be sure you don't violate the wash sale rule by repurchasing the same or "substantially identical" securities within 30 days before or after the sale, lest your losses be disallowed.

Next, focus on selling investments you've held for more than a year to take advantage of the lower long-term capital gains tax rates. (Selling assets held for a year or less could result in the higher ordinary income tax rates.) You can sell these appreciated investments as part of your regular portfolio rebalancing, using whatever's necessary to meet your spending needs and reinvesting the remainder in underweight areas of your portfolio.

If you have significant savings in tax-deferred accounts and suspect RMDs could push you into a higher tax bracket later in retirement, consider withdrawing from these accounts after reaching age 59½ and your taxable savings at the same time. With this approach, you would take withdrawals from both your tax-deferred and taxable accounts in amounts proportionate to their balances.

For example, say you have $800,000 in a traditional individual retirement account (IRA) and $200,000 in a brokerage account for a total of $1 million in savings. If you require $50,000 from your portfolio to fund your spending, you'd take $40,000 (80%) from your tax-deferred IRA and $10,000 (20%) from your taxable brokerage account using the tax-efficient withdrawal strategy mentioned above.

This strategy can help smooth out the potential spike in income caused by RMDs, Social Security, pensions, and other income, which may reduce your total taxes paid throughout retirement. Distributions from your tax-deferred accounts will be taxed as ordinary income, so the order in which you sell them doesn't matter from a tax perspective; however, you should still draw them down in a way that maintains your target asset allocation.

It's generally best to delay taking Roth IRA and Roth 401(k) funds for as long as possible so that the investments can potentially benefit from continued compound growth. This can be done since Roth accounts aren't subject to RMDs, and withdrawals are entirely tax-free after age 59½ assuming you've held the account for at least five years.

Plus, if you leave a Roth account to an heir, their withdrawals will also be tax-free. The laws could always change, but at least for now, it's one of the best assets you can pass on to the next generation.

While some retirees enjoy actively managing their investments, others might not want to get bogged down in the intricacies of handling their withdrawals and taxes. Determining which assets to sell can be complex, and some savers could benefit from working with a financial advisor, a tax professional, or an automated robo-advisor. Either way, managing your tax liability can be an effective way to help keep more money in your pocket and potentially extend the life of your savings.