Being a tax-efficient investor is important, but it may matter the most once you hit retirement, which is when you’ll want to maximize your savings to make them last as long as possible.
Let’s look at two tax-efficient ways to withdraw assets from your accounts once you enter retirement: The Traditional Approach and The Proportional Approach. In general, there are three types of retirement accounts that investors use to save: Taxable accounts, like your brokerage account, Tax-deferred accounts, like a traditional IRA or 401(k), and Tax-free accounts like a Roth IRA.The order that you withdraw from these accounts can help you limit the taxes you’ll pay, and keep more of your money working to extend the life of your assets.
Now with the “Traditional Approach,” you start by taking withdrawals from your taxable accounts first, paying any taxes that apply- depending on the investment. Once your taxable accounts are depleted, then you’d begin taking withdrawals from any tax-deferred accounts—like traditional IRAs or 401k’s—paying taxes at the ordinary income rates. But remember, when you reach the age for required minimum distributions, or RMDs, you need to begin taking withdrawals from your tax-deferred accounts. This can create a spike in your income and in the amount of tax you owe. However, it’s better than paying the 50% penalty on the amount that should have been withdrawn as an RMD. If you also have a tax-free account, like a Roth IRA, try to let it grow as long as possible, because when you do start to pull from it, your qualified withdrawals will not be taxed.The Traditional Approach is simple and can help you maximize long-term growth in both tax-deferred and tax-free accounts.
The Proportional Approach to retirement withdrawals has the potential to offer some additional benefits. With this approach you take withdrawals from both your taxable accounts and your tax-deferred accounts proportionally, based on the account balances, and leave your tax-free Roth IRAs alone to hopefully continue to grow as long as possible.This withdrawal strategy has the potential to help spread out your taxable income more smoothly in retirement and can help to reduce the spike in income caused by RMDs, which can help reduce the total taxes paid over your retirement.