Income Planning

Managing Longevity

Four tax-efficient strategies in retirement
Ways to help reduce taxes and get the income you need in retirement

New research from Fidelity’s Viewpoints. Reprinted with permission. Visit here.

It’s official: You’re retired. That probably means no more regular paycheck, and that it may be time to turn to your investments for income. Be mindful of the tax bite when doing that.

“Most people are familiar with the idea of trying to maximize their investments by reducing taxes during their earning and wealth-building years,” says Ken Hevert, Fidelity senior vice president of retirement products. “Limiting taxes on those savings in retirement is equally important.”


With that in mind, here are four tax-efficient withdrawal strategies:

Strategy #1: Consider the basic retirement withdrawal sequence.1

A straightforward strategy is to withdraw money from your retirement and investment accounts in the following order:

  • Required minimum distributions (RMDs), from traditional IRA, 401(k), 403(b), or 457 and Roth 401(k), 403(b), or 457 retirement accounts2
  • Taxable accounts, such as brokerage accounts
  • Tax-deferred traditional IRA and 401(k), 403(b), or 457 retirement accounts
  • Tax-exempt Roth IRA and 401(k)

Why in this order? First, it ensures that you take any RMDs if you’re older than 70½. (Roth IRAs don’t have RMDs while the original owner is alive.) If you don’t take the full RMD, in most cases you’ll pay a penalty of half the amount you failed to withdraw.

After you’ve taken your RMD (or if you’re not yet 70½), it may make sense to use money from taxable accounts next. You’ll likely have to sell investments, in which case you’ll pay capital gains tax on any appreciation. If you’ve held the investment for longer than a year, you’ll generally be taxed at long-term capital gains rates, which currently range from 0% to 20%, depending on your tax bracket (a 3.8% Medicare tax may also apply for high-income earners). Generally, for most taxpayers, long-term capital gains are taxed at rates no higher than 15%. That’s significantly lower than ordinary income tax rates, which in 2017 range from 10% to 39.6%, for withdrawals from traditional retirement accounts. See 2017 tax rates.

What’s more, using investments from a taxable account first for withdrawals leaves your money in tax-advantaged traditional and Roth accounts, where it has the potential to grow tax deferred or tax free. “Compounding earnings in a tax-deferred or tax-free account is a powerful way to help grow investments over time,” says Hevert.

If you’ve used up your investments in taxable accounts, turn to your traditional, tax-deferred IRAs and 401(k)s. You’ll pay ordinary income tax on withdrawals, but you can continue to leave any Roth accounts untouched, which may have significant benefits. Qualified withdrawals from Roth accounts won’t be taxed, making them a useful vehicle later in retirement. For example, if you have a significant medical bill, you can withdraw money from the Roth account to pay for it without triggering a tax liability.3

Roth accounts can also be effective estate-planning vehicles when leaving money to others. Any heirs who inherit them generally won’t owe federal income taxes on their distributions. However, if you plan to leave money to a charity, a Roth account is generally not a good choice. Estate planning is complex, so be sure to consult with an estate planning advisor and an attorney before making any decisions.

Roth accounts can also be effective estate-planning vehicles when leaving money to others. Any heirs who inherit them generally won’t owe federal income taxes on their distributions

The basic withdrawal sequence does have a potential disadvantage, however. Your tax rate may increase when you start taking money from tax-deferred traditional IRAs and 401(k) accounts. If that tax bump is a source of concern, consider the following strategy:

Strategy #2: Avoid having withdrawals bump you into a higher tax bracket

If you want to be a little more strategic with your withdrawals, you may consider taking withdrawals from a mix of taxable, tax-deferred, and possibly tax-free accounts. This can help you avoid moving into a higher tax bracket.
If you want to manage your income with a target marginal tax rate (the rate on the last dollar of income earned) in mind, consider following these steps:

  • Step 1
    For the tax year, estimate your expected taxable gross income. Next, estimate your tax deductions, exclusions, and exemptions, and subtract them from your taxable gross income. This gives you an estimate of your taxable income before withdrawals from investment accounts.
  • Step 2
    Choose a marginal tax rate you’d like to target for the tax year. A reasonable place to start is the marginal rate associated with the estimated taxable income. For example, if you expect $48,000 in taxable income (before tapping your investment accounts), you could target a marginal rate of 15%, the rate for joint filers in 2017.
  • Step 3
    Determine the amount of additional taxable income (above your estimated level in Step 1) that you can withdraw from a tax-deferred account, like a traditional IRA or 401(k), without affecting your target marginal tax rate. For example, if you’re married and file jointly, taxable income up to $75,900 is taxed at 15% for 2017. So if you estimated $22,000 in taxable income from noninvestment sources, you could afford to withdraw an additional $53,900 from tax-deferred accounts without pushing yourself into the next tax bracket.
  • Step 4
    If that is not enough to cover your living expenses and tax liabilities, withdraw from a taxable account or a tax-free Roth account. If using a taxable account, try to avoid liquidating securities at a gain, because this can generate additional taxes. If using a Roth account, make sure that you’ve met the requirements for qualified distributions, or you may face both additional taxes and penalties.

“This strategy may help you generate the cash flow you need to help meet expenses, while potentially reducing your taxes,” says Matthew Kenigsberg, vice president of Fidelity’s Strategic Advisers, Inc. “If performed consistently over time, it may help you preserve more of your investments for the future. Be sure to check with your tax advisor to make sure this approach is appropriate for you. There are cases where the benefits of this strategy aren’t worth the upfront cost.”

A hypothetical example: Meet the Smiths

Consider the following hypothetical example for Mary and Sam Smith, a retired married couple whose annual expenses total $100,000.4 The Smiths expect $42,000 in gross income (all taxable). They expect to have $20,000 in tax deductions, exclusions, and exemptions, so their expected taxable income before withdrawals is $22,000. The chart below shows two scenarios for their cash flow and taxable income.

Using a tax-smart withdrawal strategy, the Smiths withdraw most of the needed income from their traditional IRA ($53,900) and a small portion from their Roth IRA ($14,553). This leaves more investments in the Roth IRA to continue to potentially generate tax-free growth. In certain situations, however, it may be advantageous to use the Roth IRA for the entire withdrawal instead of tax-deferred or taxable accounts.

For instance:

  • When any distributions from a tax-deferred account would result in undesirable outcomes that are tied to taxable income, such as increases in Medicare costs.
  • When withdrawing from a taxable account would require selling investments held less than a year, resulting in short-term capital gains, which are taxed at ordinary income tax rates
  • When you are also trying to reduce taxes on Social Security benefits, as in Strategy #3 (see below), and withdrawals from a tax-deferred IRA or 401(k) would have an impact on the taxes on those benefits.

Your circumstances may be different from those in our example, although you may be able to apply the principles to your own situation. A tax professional can help you explore the implications of different withdrawal strategies, and help manage taxes on hard-earned savings.

Strategy #3: Limit taxation on Social Security benefits

This strategy involves actively managing withdrawals from retirement accounts. The government considers up to 85% of your Social Security benefits to be taxable, using a formula that includes most other income, plus one-half of your benefits. The objective of this strategy is to manage your income so that a smaller percentage of your Social Security benefits will be taxable.

Follow the same steps outlined in Strategy #2, with one exception: You’ll target the income thresholds that determine whether your Social Security benefits are taxable, rather than income levels associated with a tax bracket. Get Social Security thresholdsOpens in a new window.

Strategy #4: Take advantage of lower capital gains rates

You may also have the opportunity to eliminate taxes on the capital gains you realize from taxable accounts. In 2017, taxpayers in the 10% and 15% income brackets can realize long-term capital gains (or receive qualified dividends) without being taxed. In 2017, the 15% bracket tops out at taxable income of $75,900 for married couples filing jointly.

The result: If your taxable income falls into one of the two lowest tax brackets, selling stocks held longer than a year could be a tax-efficient way to generate cash flow. This strategy potentially makes most sense if you have a relatively high proportion of your retirement savings in taxable accounts and a lower amount of Social Security, pension, or annuity income.

Make informed decisions
It is important to take the time to think about taxes and have a plan to manage withdrawals from your retirement accounts. Don’t go it alone. Be sure to check with a tax advisor to see how to help reduce taxes.



1. This is a hypothetical example for illustrative purposes only. In actuality, the withdrawal sequence considers inherited accounts, annuities, HSAs, etc.
2. The list of account types mentioned here is not comprehensive.
3. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, become disabled, make a qualified first-time home purchase, or die.
4. The hypothetical scenario relies on the following assumptions: 2017 federal tax figures, married filing jointly filing status, standard deduction for married couples who are age 65 or older, two personal exemptions, no alternative minimum tax, no state income tax, taxable account has an 80% basis-to-value ratio, tax-deferred account has no basis, tax liability is funded from a taxable account, and gross income is total reported income prior to tax deductions and exemptions.
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