5-Step Tax-Smart Retirement Income Plan

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. The challenge is doing so in a way that minimizes the drag from taxes. After all, every dollar lost to taxes is one you can't spend.

"Fortunately, not all investments are subject to the same tax treatment," said Hayden Adams, CPA, CFP^®, and director of tax planning at the Schwab Center for Financial Research, "and if you liquidate them in a tax-efficient way, you could help your savings last longer."

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

If you're 73 or older, start by taking the required minimum distributions (RMDs) from your tax-deferred retirement accounts. Failure to do so means getting hit with a 25% penalty on the difference between what you withdrew and what was required.

"Because of the penalty, RMDs should be your first stop when tapping your retirement portfolio," Hayden said. (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 put it back to work in the market.

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 explained.

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.

Generally speaking, you won't owe any taxes on your original principal as 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.

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 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" below). "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 said. 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.
     
• If you have significant tax-deferred savings, it's possible that 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 could be the case, you may want to consider drawing down your tax-deferred accounts and your taxable savings at the same time.

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 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, which may reduce your total taxes paid in retirement," Hayden explained. 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.

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

"Generally, it's in your interest to hold off on tapping Roth assets for as long as possible," Hayden cautioned. 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. (Note: Roth 401(k)s are subject to RMDs for tax years 2023 and before; however, in 2024 and onward, they'll no longer have any RMD requirements).
• 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 said.

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.

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 said (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."