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How to Help Generate Tax-Efficient Retirement Income

Note: Due to the Coronavirus Aid, Relief, and Economic Security (CARES) Act, required minimum distributions (RMDs) for most retirement accounts have been waived for 2020. Learn about the RMD waiver > 


For many current and future retirees, one question is paramount: How can I ensure I don’t burn through my savings too quickly?

“Most retirees don’t have enough invested to live off the interest alone—even when combined with Social Security, pensions, and other nonportfolio income—so at some point they’ll need to start liquidating their investment assets,” says Hayden Adams, CPA, CFP®, and director of tax planning at the Schwab Center for Financial Research.

Selling investments generally triggers taxes, however, which can undercut such sales and further eat into your nest egg. “Fortunately, not all investments are subject to the same tax treatment,” Hayden says, “and if you liquidate them in an efficient way, you may be able to extend the life of your savings.”

With that in mind, here’s a step-by-step approach to making tax-smart withdrawals in retirement.

Step 1: Take your RMDs

If you turned 70½ in or before 2019, start by taking the required minimum distributions (RMDs) from your tax-deferred retirement accounts. Failure to do so means getting hit with a 50% penalty on the difference between what you withdrew and what was required. Those who turn 70½ in 2020 or later can wait until age 72 to begin taking your RMDs (see “7 SECURE Act Takeaways”).

“Because of the penalty, RMDs should be your first stop when tapping your retirement portfolio,” Hayden says. (Most financial institutions—including Schwab—can help calculate your RMDs when the time comes, or you can estimate them ahead of time using an online calculator.)

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

Step 2: Tap interest and dividends

Next, withdraw the interest and dividends—but not the original investment—from your taxable accounts. “Leaving the original investment untouched means it can continue to grow and potentially yield more dividends and/or interest in the future,” Hayden says.

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. 

Step 3: Collect principal from maturing bonds and CDs

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 while evening out your portfolio’s yields over time.

However, should you still need cash after exhausting RMDs and your interest and dividends, the principal from a maturing bond or CD is often the next place to turn—particularly if interest rates have declined and you won’t earn as much by reinvesting the proceeds.

Generally speaking, you won’t owe any taxes on your original principal, so long as you hold on to a bond or CD until its maturity date; an early sale will trigger capital gains taxes if you earn a profit on the sale.

Step 4: Sell additional assets as needed

If the income generated from Steps 1 through 3 isn’t enough to cover your expenses, you’ll need to sell additional assets to close the gap. But which accounts should you tap first—and in what proportion?

  • If you have significant tax-deferred savings, it’s possible that the size of your RMDs could push you into a higher tax bracket once they kick in, especially after accounting for Social Security, pensions, and other income. If you suspect this to be the case, you may want to consider drawing down your tax-deferred accounts alongside your taxable savings.

    With this approach, you 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 IRA and $200,000 in a brokerage account for a total of $1 million in savings. If you require an additional $50,000 in income, you’d take $40,000 (80%) from your tax-deferred IRA and $10,000 (20%) from your taxable brokerage account.

    “This strategy can help smooth out the potential spike in income caused by RMDs, which may reduce your total taxes paid in retirement,” Hayden says. 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.

     
  • If you have modest tax-deferred savings or your RMDs aren’t likely to push you into a higher tax bracket, depleting your taxable brokerage accounts first leaves your tax-deferred assets to potentially grow until RMDs kick in. To tap your taxable accounts most efficiently:
    • First, part with investments that have lost value. Your losses can be used to offset any gains you may realize—a strategy known as tax-loss harvesting (see “Using a tax loss to get a tax break,” left). “And if you don’t realize any capital gains, you can use those losses to offset up to $3,000 of your ordinary income per year until all your losses have been used up,” Hayden says. 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 lower long-term capital gains 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.
 
Using a tax loss to get a tax break

A hypothetical investor who realized $20,000 in short-term capital gains and $25,000 in capital losses could use tax-loss harvesting to cut down her tax bill.

Source: Schwab Center for Financial Research. Assumes a 32% combined federal/state marginal income tax bracket, with short-term capital gains taxed at ordinary income tax rates. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product and the example does not reflect the effects of fees.
 

Step 5: Save Roth accounts for last

“It’s in your interest to hold off on tapping Roth assets for as long as possible,” Hayden says. That’s because:

  • Withdrawals are entirely tax-free starting at age 59½, provided you’ve held the account for at least five years.
  • Roth IRAs aren’t subject to RMDs—you can leave these assets to grow indefinitely during your lifetime.
  • Withdrawals are also tax-free for your heirs. “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,” Hayden says.

Unlike Roth IRAs, Roth 401(k)s are subject to RMDs—which is why it might make sense for some people to roll over any existing Roth 401(k) accounts into a Roth IRA. Be aware, however, that converting a Roth 401(k) to a Roth IRA could reset the five-year holding requirement—unless funds are rolled into an existing Roth IRA, in which case they benefit from the holding period on that account.

If you’re considering a rollover, it’s best to check with a financial advisor before you decide.

Get help if you need it

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 would really benefit from working with a financial advisor, a tax professional, or an automated robo-advisor,” Hayden says (see “Creating tax-smart withdrawals during retirement,” below). “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.”

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Important Disclosures:

Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs. Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co. Inc. (“Schwab”), a dually registered investment advisor and broker dealer. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. (“CSIA”). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.

Schwab Intelligent Income™ is an optional feature for clients to receive recurring automated withdrawals from their accounts. Schwab does not guarantee the amount or duration of Schwab Intelligent Income withdrawals nor does it guarantee any specific tax results such as meeting required minimum distributions.

Tax-loss harvesting is available for clients with invested assets of $50,000 or more in their account. Clients must choose to activate this feature.

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 his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factor.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance and financial circumstances.

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.

Diversification and rebalancing a portfolio cannot ensure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a nonretirement account, taxable events may be created that may affect your tax liability.

A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer's plan; rolling over assets to a new employer's plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.

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