Your Retirement Withdrawal Order of Operations

Retirement withdrawal strategies are one of the most common topics that you readers write to me about. You ask questions like:

• Which accounts and which assets should you withdraw first, and why?
• How does Social Security fit in? What about required minimum distributions? IRMAA?
• How do you minimize your tax bill along the way…or are taxes even the right concern to prioritize?

I put together a popular whitepaper to tackle some of these questions – but…

…but even this whitepaper doesn’t dive deep into specific withdrawal strategies and the “correct” order of operations.

Why not?

Because your income, your account types, your cost basis, your Social Security benefit, your everything will impact the best retirement withdrawal strategy for you. There are too many corner cases and “if-then” scenarios to address everyone’s ideal withdrawal strategy in one white paper, let alone one blog post.

But I’ll come close today. Or at least I’ll try. That’s the goal.

Buckle up, because the rest of this article will provide a universal framework of fundamentals for retirement withdrawal strategies.

Some Expectations…

I don’t want to mislead you. This article is not one of my lighter, 3-minute articles.

This won’t be short. This won’t be light. This won’t be pithy. We’re diving deep.

Ok, it’s not that serious.

But even with this lengthy detail, we likely won’t go so deep as to explore every nook and cranny of your specific scenario.

With retirement withdrawals, the stakes are high and pitfalls are plentiful. We want your retirement withdrawal plan to be optimized from Day 1, yet flexible enough to change along the way and account for things like the sequence of returns risk, down markets, taxes, RMDs, IRMAA, inheritance and gifting, etc.

If you’re going to read this article, it probably means you’ve saved and invested wisely. So let’s withdraw and spend wisely too.

Answering Some Other Questions…

The main topic today is retirement withdrawal strategies.

But I finished this article and realized I should return here to point you to articles on similar topics.

For example:

How Much Can You Safely Withdraw From Your Portfolio Each Year?

We’ve answered that here.

You’re Probably Using the 4% Rule All Wrong

Is the “4% Rule” Too Risky?

How Should You Tax-Optimize Where Your Assets Live?

We’ve answered that here.

The “Asset Location” Dilemma: Tax Strategy or Tax Trap?

What Assets Should You Own? How Much Risk Should You Take? How Do You Design a Good Portfolio?

This is one of my most common topics to write about, so please go dive into the blog’s backlog of articles. Here are a couple interesting starting points:

“Asset-Liability Matching” Aligns Your Money to Your Future

Willingness, Need, and Ability: How To Determine Your Appropriate Risk

Winning the Game: Retiring at 57 with $4.2M

Now, on with the main event.

The Foundational Concepts of Retirement Withdrawals

Enough preamble. Let’s begin.

What’s the core goal of planning your retirement withdrawals? Usually, it’s one of the following:

• To maximize your after-tax lifetime income
• To ensure you can always spend what you want
• To ensure you can give (in life or in death) to people or causes you care about

No matter your personal goal, it’s essential to understand the following aspects of your situation. (Yes, we will dive further into each aspect.)

• Investment longevity requirement
• Minimizing market and longevity risk
• Tax efficiency
• Tax status of your accounts (taxable, tax-deferred, tax-free)
• Income needs and lifestyle goals
• Required Minimum Distributions (RMDs)
• Medicare IRMAA brackets
• ACA subsidy cliffs (if retiring before 65)
• Legacy or charitable goals

If you’re unsure how these bullets apply to you, it’s worth pausing to understand why.

The Standard Withdrawal Order of Operations

Imagine a large auditorium with many, many small side rooms. You quickly get a solid overview of the space when you step into the large hall. You see the size, the seating, the stage – the main aspects. But you don’t know much about the side rooms. If you want 100% understanding, you’ll need time to explore every room.

The retirement withdrawal landscape is similar. In the remainder of the article, I’ll describe the “large auditorium” of retirement withdrawals, providing a solid overview of the space. I’ll also allude to many of the “small side rooms” and perhaps even peek inside a few of them.

Most of you will walk away with an adequate “lay of the land.” Quite a few of you, in fact, will walk away with enough information to completely plan your retirement withdrawal strategy. The rest of you will feel comfortable, but perhaps wanting more details about the specific side rooms that apply to you.

Let’s talk about the “large auditorium” – the “standard” withdrawal order of operations.

What follow are rules of thumb, not laws. But they’re rooted in logic and tax math. At its core, this framework is about maximizing after-tax income over your retirement years.

Before each step, please imagine the phrase, “If you still need money…”

It might go without saying, but if you don’t need the money, you shouldn’t withdraw anything. You should allow your portfolio to continue to compound.

But rather than write, “If you still need money…” dozens of times, please imagine it’s there.

Taxable Accounts First

(“If you still need money”) You should first withdraw money from your taxable accounts. If you have “extra” cash in your bank account – that is, extra beyond your emergency fund – spend that first. It’s a no-brainer.

Next, tap into the interest and dividends that might have accrued in your taxable brokerage investing account. You will be taxed on that money anyway in the year it’s been paid out to you. Better to use it on your monthly spending needs than re-invest it and realize other taxable income elsewhere.

Typically, though not always (small side room!), you should realize capital gains in your taxable account next. Long-term capital gains have preferential tax treatment compared to normal income (e.g., withdrawals from Traditional accounts). Selling from a taxable account also creates cost-basis flexibility. You can choose which lots to sell, managing gains and losses to control your taxes. You can realize capital gains at a 0% tax rate in years with little-to-no other income. Not bad.

Tax-Deferred Accounts Next

Next, tap into your tax-deferred accounts, such as Traditional 401(k) or IRA accounts. These are the accounts where you haven’t paid a lick of tax (yet), but each dollar you withdraw will be treated as income, and be subject to income taxes.

Ideally, though, you won’t touch this account until after age 59.5. Though (side room!) there are interesting workarounds to this age limit, such as Rule 72(t) / “substantially equal periodic payments,” or SEPP.

These withdrawals are taxable as income and will affect other parts of your financial plan, such as your marginal tax bracket, Social Security taxation, and Medicare IRMAA brackets.

Nevertheless, starting withdrawals from tax-deferred/Traditional accounts from an earlier age can be smart. Doing so prevents future large RMDs that might push you into higher tax brackets or affect your Medicare premiums. Roth conversions accomplish the same goal, although the converted dollars do not end up as spendable money but instead go into your Roth IRA.

“Bracket stuffing” is a common tactic here, too. Not to be confused with a Thanksgiving dish, it describes the process of intentionally taking tax-deferred withdrawals or, more commonly, using Roth conversions to “stuff” your particular tax bracket until it’s “full” of income before getting pushed into a higher bracket.

The goal is to maximize or “fill” your lower tax brackets every year, especially if high RMDs are in your future.

The caveats are to ensure you have cash on hand to pay your taxes, to be wary of IRMAA territory, and to understand how your Social Security taxation might be affected, too. I cannot recommend this enough: you or a professional you hire should understand enough about the Federal 1040 tax return to (at least) lightly dig into your specific tax scenario. I frequently use this 1040 tax calculator for just that purpose.

Tax-Free Accounts Last (Roth, HSA)

Tax-free accounts are the “holy grail” of retirement planning. No, they don’t provide eternal life.

Or perhaps a better metaphor is the “joker” or “wild card.” In a tight tax bind, you can withdraw money from these accounts (for qualified purposes on the HSA side) with no tax consequence.

Why save them for last?

First, they are your “MVCs” – most valuable compounders. Unlike your dollars that compound with capital gains taxes or income taxes attached, these tax-free dollars compound with no taxes.

Second, they’re not subject to RMDs. You can let them compound forever.

Third, your Roth dollars are ideal for legacy giving and estate planning. Your heirs can inherit the assets, let them continue compounding, and then withdraw them after 10 years without tax consequence. [This idea does not apply to HSA dollars – you do not want to leave HSA dollars to non-spouse heirs, and we will discuss that later]

And last, these dollars provide the aforementioned tax flexibility later in life, when RMDs and IRMAA surcharges become bigger concerns. Imagine an additional surprise expense pops up in your late 70s, when you already have high RMD income. To cover your unexpected need, you could realize capital gains (possibly at 15% or 20% tax, plus the 3.8% NII tax) or realize income (at 24%, 32%, or higher tax, plus State tax). Or, you can withdraw Roth dollars tax-free. That’s a nice safety valve.

Roth dollars and HSA dollars should generally be the last dollars you withdraw.

That’s the auditorium.

• Taxable accounts first, especially with the cash you already have and the cash that’s foisted upon you (from interest and dividends).
• Tax-deferred accounts next. Mainly, because you don’t mind realizing some taxes at lower rates, and you’d rather not touch your Roth accounts too soon.
• Tax-free accounts last, because these are your MVCs – most valuable compounders.

This is the starting point. We haven’t explored the “small rooms” yet. As your retirement unfolds, many other scenarios can affect when and how to tweak this order.

Optimizing With Roth Conversions and Tax Bracket Management

The first “side room” we’ll explore involves Roth conversions and tax bracket management.

I’ve written extensively on these topics before. I recommend you start with these previous articles. I won’t copy all the details word-for-word.

Should You Consider Roth Conversions?

The Powerful Benefits of Roth Conversions

What are the critical details here?

We want to use our early retirement years for Roth conversions. These years tend to be lower income, as you’ll typically be pre-RMD and might not have started Social Security yet.

We use these low-income years to intentionally and artificially realize income in lower tax brackets by “converting” dollars from tax-deferred accounts into tax-free accounts, accomplishing the “bracket stuffing” we described above.

Is this guaranteed to be a smart tax move? We each have to make a judgment call. How do we feel about today’s known tax brackets vs. tomorrow’s uncertain ones? It’s a difficult wager. But if we feel comfortable that taxes will remain stable or increase, then Roth conversions are a smart move.

The goal is to avoid nasty future tax scenarios, like the unholy interference of RMDs and Social Security. In retirement, every extra dollar of income doesn’t just create its own tax bill, but can also pull more of your Social Security into the taxable column. It’s not just what you earn. It’s what your earnings trigger. Another goal is to simply add more “most valuable compounders” to your balance sheet.

Other Side Rooms: When and How to Break the Standard Order

What are other important “side rooms” in our retirement withdrawal optimization? Or, put another way, when should we “break the rules” of the standard order? And why?

Filling Gaps with Roth Withdrawals

In general, your retirement withdrawal plan should be measured in decades. You want to think far ahead.

After looking far into your future, you might realize that you’ll pay high marginal taxes during your early retirement years – and this will stick out like a sore thumb compared to the rest of your plan. Instead of paying those high marginal taxes, you might “fill the gap” with early Roth withdrawals.

Rather than realizing capital gains at 20% + 3.8% NIIT, or rather than withdrawing from Traditional tax-deferred accounts at 32% Fed + 7% State tax rates, perhaps you make a simple Roth withdrawal with no tax consequence.

This strategy can also manage IRMAA, ACA, or other income cliffs. These “cliffs” are (pardon my French) stupid. Going just one dollar over a cliff can result in thousands of dollars of extra costs, penalties, etc.

If you need $500 more in a particular year and withdrawing that $500 from a Traditional IRA would push you into the next IRMAA bracket – stop! Make a strategic tax-free withdrawal instead – likely from a Roth account.

Taxable Asset Liquidation – Looking At Cost Basis

As you withdraw assets from your taxable account, you might see opportunities for tax-loss harvesting and tax-gain harvesting. In short:

• Tax loss harvesting = selling investments at a loss to offset taxable gains elsewhere in your portfolio, reducing your overall tax bill.
• Tax gain harvesting = selling appreciated investments to realize gains while in a low tax bracket, often resulting in little or no tax owed.

These two practices can open up other strategic doors in your withdrawal strategy or might take precedence over your predetermined plans.

• In some years, tax-loss harvesting might open up an opportunity for extra Roth conversions or other Traditional IRA income
• In other years, you might choose to tax-gain harvest rather than pursue extra Roth conversions.

But taxable cost basis is a funny thing. Any sort of tax-loss, tax-gain, or capital gains minimization strategy highly depends on your age. Not to be crass, but “cost basis optimization” becomes a moot point when you die. Your heirs will inherit your taxable assets at a stepped-up basis.

If you’re 60 and healthy and considering this side room? Good. Go for it.

If you’re 85, in a nursing home, and taking a hard look in the mirror…well, you might not want to do any of this stuff in your taxable account.

Optimizing for Post-Death

On that same note, it’s worth asking yourself:

• Will I be leaving money to heirs after my death?
• How do I do so optimally?

Leaving money to your spouse differs from any other person in your life.

Leaving money to charity has special rules about it. Some accounts are better off going to charity than others. And if you’re giving to charity while you’re alive, there are really smart (and really dumb) ways you should be doing that, too!

Leaving money to high-earning heirs should be fundamentally different than leaving money to low-earning heirs, because their tax situation can affect the benefit (or annoyance) of your bequest to them.

Leaving money after your death is an important “side room” when it comes to optimal retirement withdrawal strategies.

The Role of Social Security Timing

When designing someone’s retirement paycheck, we generally think about fixed income sources first. We want to understand your Social Security income before determining your withdrawal order of operations. But I still wanted to touch on a few key points today.

Perhaps the biggest question to start is, “When should I take Social Security?” Rather than reinventing the wheel, I suggest you read this:

“When Should I Take Social Security?”

The key takeaways:

• Collecting Social Security can act as a “pressure release valve” on your portfolio withdrawals.
• However, delaying Social Security can open important doors in your withdrawal strategy; namely, increasing your opportunity for Roth conversions.
• Social Security taxability is an important topic. It’s worth knowing how other retirement income may affect your Social Security taxation.
• Spousal benefits and survivor benefits are also worth considering here.

What About HSAs, Annuities, Pensions, etc?

Health Savings Accounts (HSAs) are highly valuable (somewhat like Roth dollars). When used for medical expenses, HSA dollars are tax-free “most valuable compounders.” But what happens if your HSA is too big, such that you might never spend it?

First, we should answer: what happens if you die with HSA assets?

If you leave the HSA to your spouse, the account effectively becomes their HSA, with all the excellent tax-free benefits.

But if your spouse has passed, or you simply want to leave the HSA to another person, then the entire account becomes taxable income to the beneficiary in the year of your death. Ouch! This is not an ideal outcome.

For that reason, it’s worth considering a second option: If your HSA is too big, and you might never spend it, do you have another option?

Yes! Starting at age 65, you can essentially utilize HSA dollars as if they were in a Traditional IRA. You can spend the money on anything, not just medical expenses. But those withdrawals will be treated as taxable income (not tax-free income). There’s a trade-off.

Which is better? It’s a tough choice. If you spend too many HSA dollars starting at age 65, you might run out before later years when you have high medical costs. But if you die with too many HSA dollars, you might inefficiently saddle your beneficiary with a big tax bill.

What About Annuities?

All else being equal, I’d prefer not to purchase annuities in the first place. Even the few “good” annuities do not have enough investing merit to interest me. The math is clear.

A SPIA (Single Premium Immediate Annuity) is about as good as annuities come, but the rate-of-return math of a typical SPIA isn’t attractive.

A SPIA is as simple an annuity as you can get – and that’s a good thing. You trade in a chunk of your money today in exchange for lifetime income. It’s longevitiy insurance, where you and other SPIA customers essentially pool your risk together, much like the inverse of term life insurance.

As of this writing, a 65-year old male can purchase a SPIA with a 7% to 7.5% annual return payout. NOTE – the payout is NOT the same as an investment rate of return, because the annuity first pays you back your own money

By using simple internal rate of return (IRR) math, we see what a 7.5% payout equates to. If this 65-year old males dies at…

• Age 80 –> 1.5% annual rate of return for 15 years
• Age 85 –> 4.2% annual rate of return for 20 years
• Age 90 –> 5.6% annual rate of return for 25 years
• Age 95 –> 6.3% annual rate of return for 30 years

As we know from our deep dive on life expectancy, the average 65-year old American male will live to age 82. This annuity would provide a 2.8% rate of return for that average male.

That is simply not good enough.

Ok – but let’s assume you already own some annuities and you really like them.

Much like Social Security, your annuity income can create a “fixed floor” from which you can build the rest of your withdrawal strategy.

Pension income works the same way. It creates a floor.

Now, if you have control over collecting your pension or annuity income, it’s worth understanding if delaying those income sources will open other doors for you. Namely, tax doors, such as the oft-mentioned Roth conversions.

Common Mistakes and How to Avoid Them

We’ve covered so much ground! We’ve already touched on the many common mistakes. But let’s rehash them anyway. How can a withdrawal order of operations go wrong?

1. Not having a plan. Ok, I know it’s a bit of a cop-out. But this exercise is about building a plan to maximize your after-tax wealth throughout retirement. It’s about planning ahead. Perhaps there’s no greater mistake than deciding not to plan. What’s that one cliche? “Failing to plan is planning to fail.”
2. Assuming every year will be the same. Your spending will change. Your portfolio will grow and (occasionally) shrink. You’ll hit “age milestones,” such as your Social Security window, Medicare at age 65, and RMDs at age 73 or 75 (or beyond, depending on legislation). You cannot assume that every year will be the same. Your withdrawal strategy cannot be static.
3. Missing annual windows. If you forget to “bracket stuff” or you neglect a Roth conversion in a particular year, you cannot get that opportunity back. Once a year has passed, so have your tax opportunities for that year. Don’t miss your windows.
4. Ignorance of adverse interactions. Oops! You didn’t realize that extra IRA withdrawal would push you into the next IRMAA bracket? You didn’t know that Roth conversion would make Social Security more taxable? One of the challenges of a withdrawal strategy is understanding how these puzzle pieces all fit together. Don’t make the mistake of not knowing these adverse interactions.
5. Spending the wrong assets too soon. Roth and HSA assets are your MVCs – most valuable compounders. Taxable assets should usually be spent first…but not if a near-term death could prevent large capital gains realization.

Conclusion

Your ideal retirement withdrawal strategy will be a function of you and your unique circumstances. But the framework provided today should give you an excellent starting point.

Getting this step of retirement planning correct is just as important as the decades of saving, accumulating, and investing you’ve been doing. A little math and planning can add so much value.

Questions? Concerns? Did I miss something obvious? Let me know!

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