Retirement Income: Building a Tax-Efficient Withdrawal Strategy

The Three Buckets of Retirement Savings

Most retirees have accumulated savings across three distinct types of accounts, each with different tax treatment. Understanding these "buckets" is the foundation of an effective withdrawal strategy.

Bucket 1: Taxable accounts include brokerage accounts, savings accounts, and other investments held outside of retirement plans. Contributions were made with after-tax dollars, so only the gains are taxable when you sell. Long-term capital gains receive preferential tax rates (0%, 15%, or 20%), and you have full flexibility on timing and amounts.

Bucket 2: Tax-deferred accounts include Traditional IRAs, 401(k)s, 403(b)s, and similar retirement plans. Contributions were typically tax-deductible, and growth is tax-deferred. Every dollar withdrawn is taxed as ordinary income. These accounts are subject to Required Minimum Distributions (RMDs) beginning at age 73.

Bucket 3: Tax-free accounts include Roth IRAs and Roth 401(k)s. Contributions were made with after-tax dollars, growth is tax-free, and qualified withdrawals are completely tax-free. Roth IRAs have no RMDs during the owner's lifetime, providing maximum flexibility.

Conventional Withdrawal Order — and Why It Falls Short

The traditional advice is simple: spend from taxable accounts first, then tax-deferred, then Roth last. The logic is that taxable accounts generate ongoing tax drag from dividends and capital gains, so spending them first removes that drag. Meanwhile, tax-deferred and Roth accounts continue to grow in a more tax-efficient manner.

While this approach is better than no strategy at all, it often leads to a suboptimal outcome. The problem is that it allows the tax-deferred bucket to grow unchecked for years, resulting in larger RMDs that push you into higher tax brackets, increase taxation of Social Security benefits, and trigger Medicare IRMAA surcharges. A more sophisticated approach — tax bracket management — typically produces significantly better results.

Tax Bracket Management in Retirement

Tax bracket management means deliberately choosing which accounts to draw from each year based on your projected taxable income, with the goal of filling lower tax brackets efficiently and avoiding spikes into higher ones.

In practice, this often means taking some withdrawals from tax-deferred accounts even in years when you do not need the income, or supplementing tax-deferred withdrawals with Roth distributions to keep your taxable income within a target range. The key insight is that paying a moderate amount of tax consistently over many years is almost always better than paying no tax now and a large amount later.

In this hypothetical illustration, a retiree with $1.5 million in mixed accounts saves approximately $80,000 in lifetime federal income taxes by using an optimized withdrawal strategy compared to the simple "spend taxable first" approach. Individual results vary significantly based on account balances, income sources, and tax brackets.

How Withdrawals Affect Social Security Taxation

This interaction means that the source of your retirement income matters enormously. A $10,000 withdrawal from a Traditional IRA not only generates $10,000 of taxable income but may also cause an additional $8,500 of Social Security benefits to become taxable. In contrast, a $10,000 Roth withdrawal generates no taxable income and has no impact on Social Security taxation. Strategic use of Roth withdrawals can keep your combined income below the thresholds where Social Security taxation accelerates.

Impact on Medicare IRMAA Premiums

Sequence-of-Returns Risk

Sequence-of-returns risk refers to the danger that poor market returns in the early years of retirement can permanently impair your portfolio's ability to sustain withdrawals, even if average returns over the full period are acceptable. A retiree who experiences a 30% market decline in the first two years of retirement and continues withdrawing at the same rate may deplete their portfolio decades earlier than someone who experiences the same decline later in retirement.

Your withdrawal strategy can help mitigate this risk. During market downturns in early retirement, drawing more heavily from taxable accounts or Roth accounts — rather than selling depreciated assets in tax-deferred accounts — preserves the tax-deferred balance and gives it time to recover. This flexibility is one of the strongest arguments for maintaining assets across all three buckets.

Dynamic vs. Fixed Withdrawal Strategies

Fixed percentage approach. The classic 4% rule suggests withdrawing 4% of your portfolio in year one and adjusting for inflation each year thereafter. While simple and historically successful over 30-year periods, this approach does not adapt to market conditions, tax law changes, or shifts in your personal situation.

Dynamic approach. A dynamic withdrawal strategy adjusts the amount and source of withdrawals each year based on current market conditions, your tax situation, and your spending needs. In strong market years, you might withdraw slightly more and use the excess to build a cash reserve or fund Roth conversions. In down years, you reduce withdrawals, draw from cash reserves, and avoid selling depreciated assets. This approach requires more active management but typically produces better outcomes in terms of both portfolio longevity and lifetime tax efficiency.

The most effective retirement income plans combine elements of both: a baseline spending target with annual adjustments based on portfolio performance, tax bracket opportunities, and life circumstances. This is precisely the kind of ongoing, personalized planning where working with a financial advisor adds the most value.

This article is for informational purposes only and does not constitute investment or tax advice. Hypothetical illustrations are not guarantees of future results. All information should be discussed with a qualified financial advisor before implementation.