Minimize Your Tax Bill in Retirement

If you've been diligent about saving for retirement, what's the most tax-efficient way to spend down that money? If you have different types of accounts — 401(k), traditional IRAs, brokerage accounts and Roth IRAs — is there a preferable order in which to tap the funds in order to minimize what you will owe in taxes?

First, remember that once you reach age 73, the Internal Revenue Service (IRS) requires you to take what are called Required Minimum Distributions, or RMDs, from your traditional IRA or retirement plan account.

Typically, RMDs are calculated for each account by taking their balance on the prior Dec. 31 and dividing it by a life expectancy factor published by the IRS in "Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)." You are not required to take RMDs from Roth IRAs.

The owner is taxed on the RMD withdrawal amount at their income tax rate. If you fail to withdraw the full amount of the RMD by the due date, the amount you have not withdrawn may be subject to an excise tax of 25%, or, if the RMD is withdrawn within two years, 10%, according to the IRS.

Traditional IRAs you converted to Roth IRAs are not subject to RMDs because contributions to traditional IRAs are made with funds that are taxed up front.

An important point: if you receive your maximum Social Security retirement benefits because you waited until you were 70 to claim them, you may not need to spend down more money for nondiscretionary expenses such as housing, food, health care and taxes. Your Social Security and any pensions you may have cover them.

Yet, you may need or want to spend down for non-discretionary items such as far-flung trips or major home renovations. It depends on your total financial resources.

How do you decide which funds to draw down and in which order?

There are general principles for spending down your money, financial experts say.

Two basic points to consider are: (1) the different types of accounts you have, and (2) how to avoid being overtaxed as you spend.

While every situation is different, the general guidelines are:

• Spend down from your brokerage accounts first because the tax on capital gains is lower than ordinary income tax.

• Next, spend down from 401(k) or traditional IRA; you will pay income tax on withdrawals from these accounts.

• Finally, spend down from the Roth IRA last, to allow the funds to grow tax-free until you need them.

"Traditionally, we guide them to take (from) brokerage accounts first," said Kent Pearce, managing director, Merrill Private Wealth. He has offices in Towson, Maryland, and Palm Beach, Florida. "Those funds are taxed at a capital gains rate, which is lower than the ordinary income (tax) rate."

If one or more pensions and Social Security benefits cover your guaranteed expenses — housing, food and transportation — spending down your money will depend on your "desired lifestyle," said Pearce.

Planning is the key to spending your money in retirement, and it's "not one size fits all," said Nilay Gandhi, a senior wealth advisor with Vanguard. It depends on your income tax bracket and the different kinds of accounts you have. Do you have one or more brokerage accounts? A 401(k), a traditional IRA and Roth IRAs?

Say you and your spouse or partner have decided to take that long dreamed of trip to Antarctica, which could cost as much as $20,000.

How do you spend the $20,000, and keep taxes to a minimum?

If you use "savings in a money market fund, checking or savings account there are no tax implications," Gandhi said. If you use funds from equities you sell in a brokerage account, you will be faced with capital gains tax. If you use funds from long-term capital gains (investments that you have kept for at least a year and a day), they will be taxed at capital gains rates of 0%, 15% or 20%, based on your income tax bracket. Typically, the tax rate will be lower than your ordinary income tax rate.

Another option, if you are in a high-income tax bracket for the year, is to take the money from contributions to your Roth IRA as a one-time expense, Gandhi said. "It depends on the situation."

If you are in a high-income tax bracket, you may not want to spend any more taxable income, and either add to your tax liability or bump yourself into a higher tax bracket. In those cases, you might prefer to spend some contributions you made to your Roth IRA. You already would have paid tax on those contributions upfront.

According to Internal Revenue Service rules, you can take out contributions to Roth IRA at any time. However, if you are under age 59½, any earnings you tap will be included in your taxable income and may be subject to a 10% additional tax.

Alternatively, if you're planning a big expense, say, a trip or home renovation, aim to squirrel away funds for it in advance.

One couple who relocated in retirement faced taxable events. Although they had saved systematically since the early 1980s and continued to work until past 70, they have wound up using their RMDs to pay for home renovation in their new location.

The husband, aged 77, and wife, 76, have no Roth IRA, so all the money in their traditional IRA is subject to RMDs. They renovated their kitchen as well as two bathrooms, bought a new 2020 Subaru for her in 2020 and spent an estimated $30,000 to $40,000 on their yard. Once they pay for these projects with RMDs, they save the remainder of the funds.

When spending down for anticipated expenses, or even unexpected ones, the better you plan, the more likely you will take taxes into consideration. Then, consider the "technical piece," said Gandhi: "Where should I take the money from?"

If your choice will be subject to ordinary income tax, Daniel Lee, director of financial planning and advice at BrightPlan, a financial advisory and wellness benefit provider in San Jose, California, said it's useful to plan for which tax bracket you want to stay within for the year — 10%, 12%, 22%, 24% or 32%. Your decision can help you select from which account you prefer to spend.

As discussed above, there are general guidelines for the order in which to spend your money, yet "in practice it's difficult to do exactly in order," Lee said.

If you have income from Social Security and one or more pensions, spending down might be just for discretionary items such as travel and home renovations. "It's easier to plan when there's a constant stream of checks coming in from Social Security and a pension," he said. People are typically less comfortable spending down from their portfolios.

Tax planning is part of spending down your money. It is "how you minimize the taxes over your lifetime," said Lauren Zangardi Haynes, a Certified Financial Planner who founded and owns Spark Financial Advisors in Richmond, Virginia.

For example, she described how someone who was planning a $200,000 home renovation might decide to take less out of a traditional IRA to stay within a lower tax bracket for that tax year. If you have pensions and traditional IRAs but not a significant amount in a brokerage account, the cost of the renovation would have to come from the traditional IRA, she said, unless you have saved the money in a high-yield savings account.

If you spend down money from a traditional IRA and have significant pension income, the IRA distributions could be subject to between 24% and 35% in federal and state tax. You could end up spending the $200,000 plus $48,000 to $70,000 in taxes. "You have to account for the taxes" on the money you pulled out of a taxable account, Zangardi Haynes said.

"Sometimes you can use debt strategically to manage your taxes," she added. Compare the cost of borrowing the money with a home equity line of credit, or HELOC, versus taking money out of a traditional IRA: the average interest rate for a $30,000 HELOC is 8.28%; withdrawing that amount from a traditional IRA would cost as much as 32% in income tax, depending on your bracket. "Explore a variety of options," Zangardi Haynes said.

Your decision on which way to pay for the renovation can depend on what your tax liability will be if you spend down. Through 2025, if home equity loans or lines of credit secured by your primary or second home are used to "buy, build, or substantially improve the residence, interest you pay on the borrowed funds is classified as home acquisition debt and may be deductible, subject to certain dollar limitations," according to the IRS.

Indeed, the order in which to spend down your money is not a cookie-cutter decision. Consider all your sources of income and the tax consequences of how you spend it down before making a move.

Remember, if you use cash that you have saved, the spending won't incur additional income tax.

Harriet Edleson is author of the book, “12 Ways to Retire on Less: Planning an Affordable Future” (Rowman & Littlefield). A former staff writer/editor/producer for AARP, she has written for The New York Times, The Washington Post and Kiplinger's Retirement Report. Read More