Pay less taxes on your retirement income with this withdrawal strategy

by Brent G. Oneal

A woman checks her retirement accounts on her laptop. A Fidelity analysis shows that a proportional withdrawal strategy can lead to fewer taxes paid during retirement.

Do you want to pay less tax on your hard-earned retirement income and extend the life of your savings? This may be easier and simpler than you expected.

For retirees with assets spread across various segments, from taxable investment accounts to Roth IRAs, Fidelity recommends a balancedhdrawal approach that relies on all the y accounts at the start of your retirement. Rather than withdrawing assets from one account at a time, Fidelity found that proportionally withdrawing money from each account simultaneously can extend the life of your savings by lowering the taxes you pay in retirement.

Pay less taxes on your retirement income with this withdrawal strategy

A financial advisor can help you withdraw your pension assets in a tax-friendly manner and provide other pension advice. SmartAsset can help you find advisors serving your area today.

This common withdrawal strategy may cost you some.

A couple checks their retirement savings on their laptop. A Fidelity analysis found that a proportional withdrawal strategy from different accounts results in fewer taxes paid during retirement.

As Fidelity points out, tax professionals often recommend withdrawing assets from taxable accounts first, followed by tax-deferred accounts like traditional 401(k)s and IRAs, followed by Roth IRAs last. With this strategy, your Roth assets can grow tax-free, as Roth IRAs are not subject to minimum distribution requirements.

But this approach of withdrawing assets from one account at a time can result in what Fidelity calls a “tax bump” in mid-retirement.

Consider Joe, a hypothetical retiree with $200,000 in a taxable brokerage account, $250,000 in a traditional 401(k), and $50,000 in a Roth IRA. He collects $25,000 in annual Social Security benefits and has to withdraw about $35,000 from various accounts. The retiree must generate $60,000 in after-tax retirement income to meet his spending needs.

Suppose retiree relies on the traditional approach of withdrawing assets from one account at a time, starting with their taxable investment accounts. In that case, they will largely avoid taxes during their first seven years of retirement. That’s because his income will be so low that he won’t pay any long-term capital gains tax on withdrawals from his brokerage account. But that won’t last.

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After exhausting the assets in his brokerage account, Joe withdraws his traditional 401(k) accounts. However, he must pay income tax on these withdrawals. As a result, according to Fidelity’s analysis, he will pay approximately $66,000 in income taxes over the next 12 years of retirement. At this rate, Joe’s traditional 401(k)s will be tapped midway through his 19th year of retirement. From there, his Roth IRA assets will last him about four more years.

Proportional withdrawals: a fiscally smart alternative

A couple checks their retirement savings on their laptop. A Fidelity analysis found that a proportional withdrawal strategy from different accounts results in fewer taxes paid during retirement.

Fidelity says e tax-efficient alternative exists for Jexists oe and retirees like him. Taking withdrawals from all three sources spreads Joe’s tax debt and slighslightly extends his portfolio’s life.

Under this approach, Joe would withdraw about $15,000 a year from his taxable account in the first 23 years of retirement. At the same time, he would withdraw about $18,000 from his traditional 401(k) each year while supplementing those withdrawals with another $4,000 from his Roth IRA.

While this strategy would result in Joe paying taxes practically every year he retires, it would drastically reduce his tax liability compared to the more traditional withdrawal strategy. Instead of paying an estimated $65,988 in taxes during the middle part of his retirement, Joe would pay only $41,398 in estimated taxes during his entire pension. That’s a 37% reduction on his tax bill!

Bottom Line

For retirees with assets spread across multiple accounts, including taxable brokerage accounts, traditional 401(k)s, and Roth IRAs, Fidelity found that a proportional withdrawal strategy can limit your tax liability and further boost your savings. This approach is based on withdrawing all your accounts simultaneously based on the percentage of your total savings from that account.

Retirement Planning Tips

Planning your retirement can be complicated and overwhelming. A financial advisor can help you make important financial decisions about your retirement plan. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide which one is right for you. Get started now if you’re ready to find an advisor to help you achieve your financial goals.

Tracking your progress toward a savings goal is critical. SmartAsset’s Retirement Calculator can help you estimate how much savings you will have when it comes time to retire and get a better idea of ​​where you stand.

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Photo credit: iStock.com/Luke Chan, iStock.com/shapecharge, iStock.com/MCCAIG

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