5 Tax-Efficient Withdrawal Strategies During Retirement

Key Takeaways

• The conventional strategy calls for making withdrawals in this order: taxable, tax-deferred, then Roth accounts where withdrawals are tax-free.

• This Roth conversion strategy entails converting traditional IRAs to Roth IRAs during low-income years and paying regular income taxes on the converted sum.

• To optimize withdrawals in retirement, individuals need a solid understanding of tax scenarios, their financial objectives, and how accounts are structured.

Key to retirement is maximizing savings and navigating post-work life with a sound financial plan. As part of that, it is important to time withdrawals from various retirement accounts just right, using methods that can benefit the retiree more than the IRS. So, here are five tax-efficient withdrawal strategies during retirement.  

Accounts Defined

It is first necessary to define a few key account terms and what they mean for the owner and the Internal Revenue Service. They are:

• Tax-deferred accounts. With these accounts, taxes come due only when funds are withdrawn – not when contributions are made – allowing people time to invest for their retirement years.  An individual retirement account and 401(k) plan are examples of tax-deferred accounts.
• Tax-free accounts. This type of account typically refers to permanent cash-value insurance policies that offer individuals tax benefits and risk protection. Similar to a Roth IRA, a TFRA is funded with after-tax dollars. 
• Taxable accounts. These accounts, such as brokerage and savings, permit people to save and invest money beyond the contribution caps on IRAs and other retirement plans.

Different Types of Retirement Accounts and Their Tax Implications

Here are common retirement accounts and what they mean regarding taxes. Note that many individuals have multiple account types, as diversification is important in terms of cash flow, tax implications, and risk. In fact, it is in the same category as estate and legacy planning.

• Traditional IRAs and 401(k)s. IRAs are opened by individuals through a bank or broker; 401(k)s are offered through employers. While individual retirement accounts usually have more investment options, 401(k)s permit higher yearly contributions. These accounts are subject to income taxes and potentially higher tax rates the more that is withdrawn. 
• Roth IRAs and Roth 401(k)s. Roth accounts are not subject to withdrawal taxes. That is what sets them apart from traditional IRAs and 401(k)s.
• Taxable investment accounts. Taxable accounts are liable for 0% long-term capital gains rate – if regular taxable income is within applicable ranges.

Basic Tax-Efficient Withdrawal Strategies

To optimize withdrawals in retirement, the retiree needs a solid understanding of tax scenarios, financial objectives, and how accounts are structured. With that in mind, these are fundamental tax-efficient withdrawal strategies:

• The Conventional strategy. This essentially calls for withdrawals in this order: taxable, tax-deferred, then Roth accounts where withdrawals are tax-free. The aim is to permit tax-deferred assets the chance to grow over time.
• The Roth Conversion strategy. This strategy entails converting traditional IRAs to Roth IRAs during low-income years and paying regular income taxes on the converted sum. Such a conversion may be most compelling when tax is paid on the converted amount at a comparatively depressed rate.
• Proportional strategy. Here, withdrawals are proportionate to the sizes of various account types. In other words, after a target amount is established, an investor would withdraw from each account based on the account’s percentage of overall savings.

Advanced Tax-Efficient Withdrawal Strategies

Here are two more advanced ways to reduce one’s tax bill during retirement:

• Bracket-topping strategy. This essentially means filling up one’s current tax bracket with tax-deferred account withdrawals.  In other words, the retiree will each year take sufficient IRA contributions to propel taxable income to the boundaries of the next tax bracket. The distributed funds can then be invested outside the IRA, for example, or to pay taxes. 
• Capital gains strategy. This strategy calls for balancing tax brackets with capital gains rates. Retirees can lower their tax bill by taking capital gains when they are in the lower tax brackets. Single filers for the 2023 tax year with taxable income of less than $44,625 are in the lower tax brackets.

Specific Strategies for High-Income Earners

Tax planning is of utmost importance to individuals in this category since more options mean more decisions. Overall, tax-efficient investments and charitable donations are prime tax strategies for this demographic, as are Roth conversions during lower-income years.

While a retirement withdrawal strategy varies for each individual, it should start with establishing how all their assets are structured and the point at which payouts start. 

After all, for those who retired from corporate life, there could be pension or stock options, or deferred compensation. A retiree who recently sold their business may be getting payments, as part of the transaction, over several years. Then there is the person who bought an annuity decades ago and could soon be looking to activate that income stream. 

Thus, rather than assume withdrawals must be made the first day of retirement, some experts suggest constructing a five-year cash flow plan, which might include predictions about any consulting or part-time income the new retiree may earn early on. Then, a withdrawal plan can be put in place, striking a balance between taxable and tax-deferred account withdrawals.

Flexibility in Retirement Withdrawal Strategies

Underscoring the need for a financial planner or other tax professional, retirees may need to adjust their strategies based on changes to tax laws, which professionals keep track of, and to life changes.  

Some retirement planners say a more flexible withdrawal approach permits the retiree to withdraw funds based on their needs, with the proviso that they remain within certain guardrails – maintaining a certain dollar amount, for instance. For example, retirees could begin withdrawing at a higher rate and adjust that downward when necessary.

Ultimately, retirement is all about change, and there may be a need to adapt to personal life changes. Such changes could necessitate retirement withdrawal pivots.

Change can also mean revising the makeup of one’s investment holdings. A more modern portfolio is not merely limited to stocks and bonds but includes other assets that diversifies it. Diversification is key to successful long-term investing.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Of all the seasons of life, retirement is a time during which most people want to hold onto – if not generate — as much money as possible, rather than send it to Uncle Sam. Employing these tax-efficient withdrawal strategies can help. And do keep in mind the importance of a diversified investment portfolio and how to put one together. That also can help make for a better retirement.