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Five Do’s and Don’ts for Tax-Efficient Retirement Withdrawals

Five Do’s and Don’ts for Tax-Efficient Retirement Withdrawals

After all those years building your nest egg, you’ll want to make sure your money sees you through retirement—which is where managing your taxes can help. Here are five do’s and don’ts to help increase the tax-efficiency of your retirement account withdrawals.

DO: Diversify your accounts.

Even before you retire, you can take steps to help make your future withdrawals more tax-efficient. One strategy is to spread your retirement savings across a variety of accounts with different tax treatments, including tax-deferred, taxable, and tax-free Roth accounts. This gives you options that can help you better manage your taxable income and potentially minimize taxes once you retire.

For example, say you invest in a tax-deferred 401(k) or IRA, a taxable brokerage account, and an after-tax Roth IRA. Withdrawals from your tax-deferred account, including IRS-mandated required minimum distributions (RMDs), will be subject to ordinary income tax rates. But income from your brokerage account may be taxed at a lower rate. And Roth IRA withdrawals are tax-free, once you turn 59½ and have held your account for at least five years. In addition, brokerage accounts and Roth IRAs aren’t subject to RMDs. 

If you have a range of account types, you can tap the ones that make the most sense for you—which may help you manage your taxable income and tax bill. But if you have all your money in tax-deferred accounts, your options will be more limited.

Taxable brokerage accounts may have another benefit: You may be able to use losses on assets in your brokerage account to lower your tax bill by leveraging a strategy called tax-loss harvesting. Tax-loss harvesting has the potential to reduce capital gains you’ve made in the same year by the amount you’ve lost—and offset ordinary income through a deduction of up to $3,000.

DO: Weigh your options.

There’s more than one way to withdraw your savings. “The most tax-efficient strategy depends on your particular situation—your accounts and assets, other income sources (like Social Security), spending needs, and other factors, says Hayden Adams, CPA, CFP®, and director of tax planning at the Schwab Center for Financial Research.

With a traditional withdrawal approach, you’ll take money out of one type of account at a time, starting with taxable accounts, then tax-deferred, and finally tax-free Roths only after your other accounts are depleted. This can reduce taxes in the early and later years of retirement, but may cause a tax spike during the middle years due to RMDs and ordinary income tax on tax-deferred withdrawals.

To avoid a tax spike, consider a proportional approach. This involves withdrawing money from taxable and tax-deferred accounts each year, in proportion to your overall savings. For example, if you have $600,000 in a 401(k) and $400,000 in a brokerage account, you’d pull 60% of the income you need from your 401(k) and 40% from your brokerage account. In short, you’d draw down your highest-taxed assets along with your lower-taxed assets—which could help you stay in a lower tax bracket each year and pay less tax in retirement.

If your risk of being pushed into a higher tax bracket by RMDs is low, the traditional approach could make sense. “But it’s not for everyone,” says Hayden. “In cases where RMDs boost your tax bracket, a proportional method may be more tax-efficient.”

DO: Hold off on tapping Roth assets.

Roth withdrawals are usually tax-free in retirement, so these assets are among the most tax-efficient you can own. While contributions are paid with after-tax dollars (meaning you’ve already been taxed), the assets will grow tax-free. To help offset those initial taxes, it’s ideal to leave your Roth assets untouched and potentially growing as long as possible.

“Keeping your tax-free Roth accounts invested until you really need them may have potential benefits whether you choose a traditional or proportional withdrawal approach,” says Hayden. “If you don’t end up using the money in retirement, you can pass the Roth IRA’s tax-free status on to your heirs.”

On the other hand, passing on tax-deferred 401(k) or IRA assets will generate a tax bill for your heirs when they make withdrawals. This is especially true if they’re subject to new SECURE Act rules for inherited retirement accounts.

DON’T: Let RMDs sneak up on you.

A spike in taxable income and a higher tax bracket are just two potential tax consequences of RMDs. Another equally important one is the 50% penalty you’ll pay on any portion of the required amount you don’t withdraw by the deadline.

  • If you turned 70½ in 2019, your first RMD is due by April 1, 2020 and subsequent ones will be due by December 31 each year.
  • If you turn 70½ after 2019, RMDs won’t kick in until you’re 72.

For the best tax outcome, consider working with a financial consultant or tax advisor to discuss how RMDs should fit into your overall withdrawal plan.

DON’T: Assume every year will be the same.

Some years, you may need to take larger withdrawals (for a vacation, gift, or other need)—while other years you may spend far less.

In years when your living expenses are lower, consider withdrawing extra assets from your tax-deferred accounts, stopping just short of the next (higher) tax bracket. If you don’t need the money immediately, you could convert some of it to a Roth IRA or invest in a taxable brokerage account. This may help reduce your risk of being pushed into a higher tax bracket in future years, when RMDs begin or if tax laws change.

Expect the unexpected

Other considerations are likely to come into play as your life and the markets change. In a prolonged up or down market, for example, you may need a new plan for which assets to tap or sell.

For expert insights or guidance on any aspect of retirement withdrawals you’re not sure about, consider working with a financial consultant, tax advisor, or both.

What You Can Do Next

Important Disclosures

Withdrawals from tax-deferred retirement accounts are subject to ordinary income tax. Prior to age 59½, they may also be subject to an early withdrawal penalty.

Roth earnings can be withdrawn tax-free after age 59½, if you’ve held the account for at least five years.

Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax-free, and subsequent conversions will require their own 5-year holding period. Prior to age 59½, earnings may also be subject to an early withdrawal penalty.

Investing involves risk, including loss of principal. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment decision. 

Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market. 

This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor, CPA, financial planner, or investment manager.


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