By W Financial Advisors • Wealth Wednesday Brief • 3–5 min read
SCENARIO
Patricia and her neighbor James retired the same year, at the same age, with portfolios nearly identical in size. Five years into retirement, they compared notes. Patricia's portfolio had held up noticeably better, not because she had spent less, but because she had been more thoughtful about where her spending came from.
"I just pull from my IRA," James said. "It's the biggest account I have." Patricia had been doing something different. She'd been working with her advisor to draw from her accounts in a specific sequence, one designed to minimize her lifetime tax bill, not just her current year tax bill.
The difference in outcomes over a decade can be significant. Withdrawal sequencing is one of the most underutilized planning levers available to retirees.
THE CONCEPT
Most retirees hold money in three different types of accounts, each with a distinct tax character:
Taxable accounts (brokerage accounts) hold assets that have already been taxed. When you sell, you may owe capital gains tax, but only on the growth, not the original investment. If you've held assets for more than a year, those gains are typically taxed at preferential long-term rates.
Tax-deferred accounts (traditional IRAs, 401(k)s, 403(b)s) hold pre-tax money. Every dollar you withdraw is added to your ordinary income in that year and taxed accordingly. These accounts also carry Required Minimum Distributions starting at age 73, which force taxable withdrawals whether you need the money or not.
Tax-free accounts (Roth IRAs, Roth 401(k)s) hold after-tax money that grows and can be withdrawn tax-free, with no RMDs during the account owner's lifetime.
The sequencing question is: in what order should you draw from these buckets?
EXAMPLE
Consider Mark, a 67-year-old retiree with $800,000 in a traditional IRA, $200,000 in a taxable brokerage account, and $150,000 in a Roth IRA. He needs $70,000 per year after Social Security.
If Mark simply pulls everything from his IRA, he adds $70,000 to his taxable income each year. As his IRA grows through his early 70s (he doesn't yet need all of it), his future RMDs may be large, potentially pushing him into a higher bracket or triggering IRMAA Medicare surcharges.
Alternatively, his advisor suggests spending from his taxable brokerage account first, keeping IRA withdrawals only as large as needed to fill his current tax bracket efficiently, and letting the Roth grow untouched. In years where his taxable account is depleted, he may also consider Roth conversions to reduce the future IRA balance before RMDs begin. Over a decade, this approach may meaningfully reduce his total lifetime tax liability.
STRATEGY
A commonly used sequencing framework works as follows, though it should always be tailored to individual circumstances:
- First: Spend from taxable brokerage accounts. This uses assets with potentially favorable capital gains treatment and leaves tax-deferred and tax-free accounts to continue growing.
- Second: Draw from tax-deferred accounts (IRAs, 401(k)s), but thoughtfully. Consider withdrawing enough to fill your current tax bracket efficiently, especially in years before Social Security begins or before RMDs are required. This may reduce the size of future forced distributions.
- Last: Tap Roth accounts. Because Roth withdrawals are tax-free and Roth IRAs have no RMDs, preserving these accounts as long as possible may maximize tax-free growth and provide flexibility in higher-income years.
- Overlay: Roth conversions in low-income years. If you have a gap between retirement and the start of Social Security or RMDs, strategic partial conversions of IRA assets to Roth may reduce your future tax burden.
COMMON MISTAKE
The most common mistake in withdrawal sequencing is a default to whatever is easiest, typically pulling from the largest account without considering the tax implications. For many retirees, that's the traditional IRA.
Withdrawing heavily from tax-deferred accounts in early retirement while leaving taxable and Roth accounts untouched can inadvertently create very large RMDs later, ones that generate more taxable income than the retiree actually needs, push Social Security benefits into higher taxation thresholds, and trigger IRMAA surcharges on Medicare premiums. A little planning early in retirement can prevent a significant tax problem later.
KEY TAKEAWAY
The order in which you withdraw from your various accounts can have a meaningful impact on your lifetime tax bill; coordinating your sequencing strategy with a financial advisor, ideally before you retire, may be one of the most valuable conversations you can have.
This article is for informational and educational purposes only and should not be construed as personalized investment, tax, or financial advice. All examples are hypothetical and for illustrative purposes only. Please consult a qualified financial professional regarding your individual situation. W Financial Advisors is an independent registered investment adviser. Some IRAs have contribution limitations and tax consequences for early withdrawals. For complete details, consult your tax advisor or attorney. Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty. Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
Every situation is different. If you would like to think through how this applies to your plan, we are here to help.
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