Understanding the Order of Withdrawals In Retirement

When entering retirement, one of the most important financial questions you’ll face is: What’s the smartest order to pull funds from my various retirement accounts? Getting this order wrong can lead to unnecessary taxes, reduced portfolio longevity, and even higher Medicare premiums.

While there’s no universal rule that fits everyone, there are strategic guidelines that can help most retirees withdraw more efficiently and keep more of what they’ve saved.

1. Use Tax-Deferred Accounts (Traditional IRA / 401(k))

For clients who have both after-tax brokerage accounts or cash reserves as well as pre-tax retirement accounts, they are often surprised to find out that there are large tax advantages to taking distributions from pre-tax retirement accounts in the early years of retirement.  Since all Traditional IRA and 401(k) distributions are taxed, retirees unknowingly will fully deplete their after-tax sources before turning to their pre-tax retirement accounts.

I’ll explain why this is a mistake.

When most individuals retire, their paychecks stop, and they may, tax-wise, find themselves in low to medium tax brackets. Knowing they are in low to medium tax brackets, by not taking distributions from pre-tax retirement accounts, a retiree could be wasting those low-bracket years.

For example, Scott and Kelly just retired. Prior to retirement their combine income was $300,000.  Scott and Kelly have a cash reserve of $100,000, an after tax brokerage account with $250,000, and Traditional IRA’s totaling $800,000.  Since their only fixed income source in retirement is their social security benefits totaling $60,000, if they need an additional $20,000 per year to meet their annual expenses, it may make sense for them to withdrawal that money from their Traditional IRAs as opposed to their cash reserve or brokerage account.

Reason 1:  For a married couple filing a joint tax return, the 12% Federal tax bracket caps out at $96,000, that is relatively low tax rate. If they need $20,000 after tax to meet their expenses, they could gross up their IRA distribution to cover the 12% Fed Tax and withdrawal $22,727 from their IRA’s and still be in the 12% Fed bracket.

Reason 2: If they don't take withdrawals from their pretax retirement accounts, those account balances will keep growing, and at age 75, Scott and Kelly will be required to take RMD’s from their pre-tax retirement account, and those RMDs could be very large pushing them into the 22% Fed tax bracket. 

Reason 3:  For states like New York that have state income tax, depending on the state you live in, they may provide an annual state tax exemption for a certain amount of distributions from pre-tax retirement accounts each year.  In New York, the state does not tax the first $20,000 EACH YEAR withdrawn from pre-tax retirement accounts.  By not taking distributions in their early years and retirement, a retiree may be wasting that annual $20,000 New York state exemption, making a larger portion of their IRA distribution subject to state tax in the future.

For client who have both pre-tax retirement accounts and after-tax brokerage accounts, it can sometimes be a blend of the two, depending on how much money they need to meet their expenses. It could be that the first $20,000 comes from their Traditional IRA to keep them in the low tax bracket, but the remainder comes from their brokerage account.  It varies on a case-by-case basis.

2. After-Tax Brokerage Accounts and Cash Reserve (Brokerage)

For individuals who retire after age 59 ½, the distribution strategy usually involves a blend of pre-tax retirement account distributions and distributions from after-tax brokerage accounts.  When selling holdings in a brokerage account to raise cash for distributions, retirees have to be selective as to which holdings they sell.  Selling holdings that have appreciated significantly in value could trigger large capital gains, adding to their taxable income in the retirement years.  But there are typically holdings that may either have minimal gains that could be sold with very little tax impact or holding that have long-term capital gains treatment taxed at a flat 15% federal rate.  Since every dollar is taxed coming out of a pre-tax retirement account, having after-tax cash or a brokerage account can sometimes allow a retiree to pick their tax bracket from year to year.

There is often an exception for individuals that retire prior to age 59½ or in some cases prior to age 65.  In these cases, taking withdrawals from after-tax sources may be the primary objective.  For individual under the age of 59 1/2 , if distributions are taken from a Traditional IRA prior to age 59 1/2, the individual faced taxation and a 10% early withdrawal penalty.

Note: There are some exceptions for 401(k) distributions after age 55 but prior to age 59 1/2.

For individuals who retire prior to age 65 and do not have access to retiree health benefits, they frequently have to obtain their insurance coverage through the state exchange, which has income subsidies available. Meaning the less income an individual shows, the less they have to pay out of pocket for their health insurance coverage. Taking taxable distributions from pre-tax retirement accounts could potentially raise their income, forcing them to pay more for their health insurance coverage.  If instead they take distributions from after-tax sources, they could potentially receive very good health insurance coverage for little to no cost. 

3. Save Roth IRA Funds for Last

Roth IRAs grow tax-free and offer tax-free withdrawals in retirement. Because they don’t have RMDs and don’t increase your taxable income, Roth IRAs are ideal for later in retirement, or even as a legacy asset to pass on to heirs. To learn more about creating generational wealth with Roth Conversions, watch this video.

Keeping your Roth untouched early in retirement also gives you flexibility in higher-income years. Need to take a larger withdrawal to fund a home project or major expense? Roth distributions won’t impact your tax bracket or Medicare premiums.

4. Special Considerations

Health Savings Accounts (HSAs):
If you have a balance in an HSA, use it for qualified medical expenses tax-free. These can be especially valuable in later years as healthcare costs increase.

Social Security Timing:
Delaying Social Security can reduce taxable income in early retirement, opening the door for Roth conversions and other tax strategies.

Sequence of Return Risk:
Withdrawing from the wrong accounts during a market downturn can permanently damage your portfolio. Diversifying your income sources can reduce that risk.

5. Avoid These Common Withdrawal Mistakes

Triggering higher Medicare premiums (IRMAA): Large withdrawals can push your income over thresholds that increase Medicare Part B and D premiums.

Missing Roth Conversion Opportunities: Processing Roth conversions to take advantage of low tax brackets and reduce future RMDs.

Tapping after-tax accounts too early: Maintaining a balance in a brokerage account can provide more tax flexibility in future years, and when it comes to estate planning these asset receive a step-up in cost basis before passing to your beneficiaries.

Final Thoughts

The order you withdraw your funds in retirement can significantly affect your taxes, benefits, and long-term financial security. A smart strategy blends tax awareness, income needs, and market conditions.

Every retiree’s situation is unique and working with a financial planner who understands the coordination of retirement income can help you keep more of your wealth and make it last longer.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Frequently Asked Questions (FAQs):

What is the best order to withdraw funds from retirement accounts?
The “best” withdrawal strategy truly varies from person to person. A common mistake retirees make is fully retiring and withdrawing money first from after-tax sources, then, once depleted, from pre-tax sources. Depending on the types of investment accounts someone has and their income needs, a blended approach can often be ideal.

Why might it make sense to take IRA withdrawals early in retirement?
Early retirement years often come with lower taxable income, allowing retirees to withdraw from pre-tax accounts at favorable tax rates. Doing so can reduce the size of future RMDs and help avoid being pushed into higher tax brackets later in life.

How do after-tax brokerage accounts fit into a retirement income strategy?
After-tax brokerage accounts offer flexibility since withdrawals are not fully taxable—only gains are. They can help retirees manage their tax brackets from year to year, especially when balancing withdrawals from pre-tax and Roth accounts.

When should retirees use Roth IRA funds?
Roth IRAs are typically best reserved for later in retirement because withdrawals are tax-free and don’t affect Medicare premiums or tax brackets. They also have no required minimum distributions, making them valuable for legacy or estate planning.

How can withdrawal timing affect Medicare premiums?
Large distributions from pre-tax accounts can raise your income and trigger higher Medicare Part B and D premiums through the Income-Related Monthly Adjustment Amount (IRMAA). Spreading withdrawals over multiple years or using Roth funds strategically can help avoid these surcharges.

What are common mistakes to avoid when withdrawing retirement funds?
Common pitfalls include depleting after-tax accounts too early, missing Roth conversion opportunities, or taking large taxable withdrawals that increase Medicare costs. Coordinating withdrawals with tax brackets and healthcare needs can help prevent these costly errors.

How does delaying Social Security affect retirement withdrawal strategy?
Delaying Social Security reduces taxable income in early retirement, which can open opportunities for Roth conversions or strategic IRA withdrawals. Once benefits begin, managing income sources carefully helps minimize taxes and maximize long-term income.

Roth Conversions In Retirement

Roth conversions in retirement are becoming a very popular tax strategy.  It can help you to realize income at a lower tax rate, reduce your RMD’s, accumulate assets tax free, and pass Roth money onto your beneficiaries.   However, there are pros and cons that you need to be aware of, because processing a Roth conversion involves showing more taxable income in a given year. Without proper tax planning, it could lead to unintended financial consequences such as:

·         Social Security taxed at a higher rate

·         Higher Medicare premiums

·         Assets lost to a long term care event

·         Higher taxes on long term capital gains

·         Losing tax deductions and credits

·         Higher property taxes

·         Unexpected big tax liability

In this video, Michael Ruger will walk you through some of the strategies that he uses with his clients when implementing Roth Conversions. This can be a very effective wealth building strategy when used correctly.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.