Tax-Efficient Withdrawals: Minimizing Tax Impact in Retirement

When building an effective, long-term retirement income strategy, you must preserve your hard-earned wealth. With no more steady paychecks coming your way, you and your advisor must work together to build a sustainable withdrawal strategy that protects the longevity of your portfolio while addressing your financial obligations today.

Some retirees may not realize just how impactful taxes can be on the overall success of their withdrawal strategy. Your different sources of income in retirement will come with varying tax treatments (even potential tax penalties), and it’s essential to consider those factors when building out your new retirement “paycheck” each year.

Here are a few important considerations you can incorporate into your planning to minimize the impact of taxes on your retirement income.

Understanding Your Retirement Accounts

Depending on your employer benefits and savings strategy, you may have accumulated retirement income within several different tax-advantaged accounts:

• 401(k)
• 403(b)
• TSP
• IRA
• SEP IRA or Solo 401(k)
• Roth IRA or Roth 401(k)

Most retirement savings accounts either offer tax-deferred or tax-free growth.

For example, 401(k), 403(b), and traditional IRA are some of the most common tax-deferred accounts available. The contributions to these accounts are deducted from your taxable income, and the funds inside the account grow tax-deferred. It isn’t until you withdraw from your account in retirement that you will be responsible for paying income tax on both the initial contributions and account earnings.

A Roth account, like a Roth IRA or 401(k), offers tax-free growth. However, the contributions made to the account are not initially tax deductible. The tradeoff is that the funds within the account grow tax-deferred, and qualified distributions are tax-free altogether. 

Tax Liability in Retirement

Understanding the potential tax advantages of your retirement savings accounts is essential, as you can use these funds to help offset other taxable income in retirement.

Your taxable income sources could include:

• Social Security benefits (if your combined income exceeds the threshold)
• Withdrawals from brokerage accounts
• Pension payments
• Interest or dividends
• Income from rental properties or other investment income

Your taxable income may be taxed at your ordinary tax rate—though some investment income may be taxed as capital gains. 

If you’re incorporating these sources of income (or any other taxable income) into your withdrawal strategy in retirement, just keep in mind how it’ll impact your overall tax bill.

How to Create Tax-Efficient Withdrawals

Everyone’s withdrawal strategy will look a little different since it’ll depend on your unique sources of income, withdrawal rate, and goals. However, there are a few key strategies to ensure you’re making tax-focused decisions with each withdrawal.

Plan for Your RMDs: Required minimum distributions (RMDs) are mandatory for those over 73 with traditional IRA or 401(k)s. You must withdraw your RMDs each year, which are determined based on your account amount and life expectancy. As a reminder, withdrawals from tax-deferred accounts are subject to income tax—meaning RMDs will increase your taxable income for the year. Not taking them, however, can result in a staggering 50% excise tax (which may drop to 25% or 10% if corrected within two years).

The good thing about RMDs is that you know they’re coming, which means you can incorporate them ahead of time into your withdrawal strategy. If you’d like to avoid RMDs altogether, however, you may want to consider utilizing a Roth conversion ahead of retirement.

Roth Conversion: You can roll over funds from a traditional 401(k) or IRA into a Roth IRA. By doing so, you can create more tax-free income for retirement. The catch? You’ll be responsible for paying income tax on any amount rolled over, and you’ll need to hold the account for at least five years before taking qualified, tax-free distributions.

Tax Bracket Management: In retirement, you and your advisor should closely monitor your tax bracket as you start building out your withdrawal strategy. For example, if you’re close to creeping into the next bracket, you could inadvertently increase your tax liability. On the other hand, you may find opportunities to limit your taxable income (such as making charitable contributions) and drop down into the next bracket and save some additional dollars. 

Other Areas of Focus

Aside from assessing your various accounts and income types, a few other factors could impact your retirement tax bill.

Healthcare

Today’s average 65-year-old couple is expected to need around $315,000 to cover lifetime medical expenses in retirement.¹ One way to save for future healthcare costs tax-effectively is to open a health savings account (HSA) if your insurance plan allows it.

An HSA offers triple tax advantages:

• Contributions are tax-deductible
• Earnings within the account grow tax-deferred
• Withdrawals used for qualified medical expenses are tax-free

As a bonus, once you turn 65, you no longer have to use your HSA to pay for qualified medical expenses either. You can treat it like a 401(k) or IRA, meaning you can spend the money however you want (but it will be taxed as ordinary income).

Estate Planning

Depending on the size of your estate (and the state you live in), you may be concerned about transferring your assets to loved ones in a tax-efficient manner. Namely, you may want to find opportunities to minimize your estate’s net worth if you believe it’s close to or above the federal estate tax exemption limit. 2024, for example, the exemption limit is $13.61 million per person.² Keep in mind that some states also implement their own estate or inheritance tax, which may have differing exemption limits.

You can work with your advisor and estate attorney to find opportunities to minimize estate or inheritance taxes by incorporating specific strategies such as:

• Gifting: Throughout your lifetime, you can “gift” a certain amount of money or assets to family and friends before triggering a gift tax. Doing so could help lower your estate’s net worth while ensuring a successful asset transfer to your intended heirs.
• Charitable contributions: If you’re especially philanthropically focused, you may want to donate a portion of your estate to charity, perhaps through a direct donation, charitable trust, or donor-advised fund. In most cases, your charitable contributions can be deducted from your estate’s net worth and reduce your tax liability.
• Trusts: Depending on your goals and the size of your estate, you may find it helpful to establish a trust and transfer property into the trust’s name. Doing so could help you avoid some tax liability, though you’ll want to confirm the specifics with your attorney during the creation process.

Tax Law Changes

When new legislation is passed, it has the potential to impact your tax liability (for better or worse). For example, the 2017 Tax Cuts and Jobs Act increased the standard deduction and doubled the estate tax exemption limit. More recently, we’ve seen tax changes geared toward retirees established in the SECURE 2019 Act and 2022’s SECURE 2.0 Act. 

It’s important to work with a financial professional who can monitor these changes as they occur and adjust your withdrawal strategy accordingly.

Make the Most of Your Retirement

Taxes play an important role in retirement, especially as you navigate multiple sources of income with varying tax treatments. If you’d like to learn more about developing and executing a forward-focused retirement income strategy, don’t hesitate to reach out to our team today. We’d be happy to discuss the benefits of personalized tax planning and answer any questions you may have.

^Sources:

^{1How to plan for rising health care costs}

^{2Estate Tax}