You’re Probably Withdrawing From Your Retirement Savings All Wrong - Here’s How To Fix It

After years of saving, retirement is the time when you start pulling money from savings and investment accounts. However, it's easy to make mistakes when drawing down your nest egg.

For many of us, the instinct is to simply pull from the account that feels most convenient. But it often makes more sense to make withdrawals in a tax-efficient manner that boosts your financial fitness by extending a portfolio's longevity.

Why it matters

Fidelity Investments offers an example of why withdrawing money in a tax-efficient manner truly matters. The company uses the hypothetical example of a 62-year-old single man whose lifestyle requires an after-tax income of $60,000. He has the following accounts:

• $200,000 in taxable accounts (with $80,000 in cost basis)
• $250,000 in a traditional 401(k) plan and IRAs
• $50,000 in Roth accounts

The man earns a 5% return on those accounts and also gets $25,000 annually from his Social Security benefits. Drawing from his taxable account first, then his traditional account, and finally his Roth, his savings stretch to 23 years with a total tax bill of just over $56,000. On the other hand, if he makes proportional withdrawals from his accounts, his tax bill drops substantially to just $34,000. That helps his money last nearly an extra year.

Is the conventional wisdom ever right?

The conventional wisdom is to drain taxable accounts first, then move on to tax-deferred accounts, and end with Roth accounts.

In some cases, this could make sense. However, it's rarely the best strategy across a long retirement. Instead, there is a better approach.

A better solution: bracket management

A more effective strategy for many retirees is to use bracket management. With this approach, you figure out which marginal tax bracket you fall into. Then, you target it.

This means you start by taking money from taxable accounts whenever doing so generates only a small tax bill, or no taxes at all. You also take withdrawals from a traditional IRA or 401(k) plan, but only to the point that you reach the top of your tax bracket for the year.

Finally, you could tap into the Roth if you absolutely need more cash. Taking withdrawals from a Roth does not trigger a tax bill.

Why bracket management works

Bracket management offers many benefits. For example, withdrawing from traditional IRA and 401(k) accounts and slowly reducing their balance keeps you from detonating a "tax bomb" once the government requires you to begin making required minimum distributions at age 73.

People who leave those tax-deferred accounts untapped right up to age 73 may be forced to make massive mandatory distributions that could create large tax headaches. By contrast, gradually drawing down these accounts throughout your 60s might result in lower overall tax bills.

In addition, using the bracket-management strategy to make occasional Roth withdrawals could keep you from drifting into a higher tax bracket. Withdrawals from Roth accounts do not create taxable income. Strategic Roth withdrawals might even prevent you from paying taxes on your Social Security benefits or having to pay more in Medicare premiums due to an income-related monthly adjustment amount (IRMAA).

Another tax-reducing strategy

Another way to potentially reduce taxes is to make sure you strike the right balance between when you make withdrawals from a traditional IRA or 401(k) plan and when you file for Social Security benefits.

For example, you might find that delaying filing for Social Security is wise during the period that you slowly withdraw from traditional retirement accounts. This allows you to keep your taxable income lower during those years.

Delaying Social Security could also make sense during a period when you plan to convert traditional IRA and 401(k) accounts to Roth IRA status.

Which approach is right for you?

Of course, no withdrawal strategy is right for every retiree. While bracket management makes sense for a lot of folks, it isn't necessarily the best move for everyone.

Your own financial and life circumstances determine which approach works best for you. The key is to weigh both your expenses and lifestyle desires and to find the strategy that helps you reach your financial goals.

Consider turning to professionals for help

Choosing the right retirement savings withdrawal strategy could be challenging. Some retirees may find that they could benefit from a bit of expert help.

Talk to a financial advisor, tax professional, or both about your options and which path forward is best for you.

Bottom line

A carefully crafted withdrawal strategy should be a key element of any sound retirement plan. Seniors who do not plan well in their 50s and 60s often face forced RMDs in their 70s that push them into higher tax brackets year after year. This could trigger IRMAA surcharges, make more of their Social Security benefit taxable, and reduce the value of their estate.

All of this is avoidable with earlier, intentional planning. If you are unsure of the right strategy for your situation, consider meeting with a money professional today who is able to offer expert guidance regarding the future.