Most retirees draw from their accounts in the wrong order — paying far more in taxes than necessary. A coordinated retirement income strategy considers the tax character of each account, the interaction with Social Security and Medicare, and the long-term estate planning implications of each withdrawal decision.
The Three Buckets of Retirement Assets
Most retirees have assets in three distinct 'buckets,' each with different tax characteristics:
Taxable Accounts (Brokerage Accounts): Assets in taxable brokerage accounts are subject to capital gains tax when sold. Long-term capital gains (assets held more than one year) are taxed at preferential rates — 0%, 15%, or 20% depending on income. Dividends and interest are taxed as ordinary income in the year received.
Tax-Deferred Accounts (Traditional IRAs, 401(k)s): Contributions to these accounts were made pre-tax, and all withdrawals are taxed as ordinary income. These accounts are subject to Required Minimum Distributions beginning at age 73.
Tax-Free Accounts (Roth IRAs, Roth 401(k)s): Contributions to these accounts were made after-tax, and qualified withdrawals — including all growth — are completely tax-free. Roth IRAs are not subject to RMDs during the owner's lifetime.
The Conventional Wisdom — and Why It's Often Wrong
The conventional wisdom in retirement income planning is to draw from taxable accounts first, then tax-deferred accounts, and finally Roth accounts — preserving the tax-free Roth assets as long as possible. This approach has intuitive appeal: let the tax-free money grow as long as possible.
But this conventional approach ignores several important factors:
RMD Accumulation: If you draw only from taxable accounts in early retirement, your traditional IRA continues to grow — potentially resulting in very large RMDs at age 73 that push you into high tax brackets and trigger IRMAA surcharges.
Roth Conversion Opportunity: The early retirement years — before RMDs begin — may be the optimal time to convert traditional IRA assets to Roth at low tax rates. Drawing from taxable accounts while converting traditional IRA assets can result in a much better long-term tax outcome.
IRMAA Management: Drawing from taxable accounts may result in capital gains that push you above IRMAA thresholds, while drawing from Roth accounts produces no taxable income.
The Coordinated Approach: Annual Tax Planning
The optimal retirement income strategy is not a fixed rule — it is an annual exercise in tax optimization that considers your current income from all sources, your projected future income, your IRMAA exposure, and your estate planning goals.
Each year, your financial advisor and tax advisor should work together to answer questions like:
- How much can we convert to Roth this year while staying below the next IRMAA tier? - Should we realize capital gains this year to take advantage of the 0% long-term capital gains rate? - How much of this year's living expenses should come from taxable accounts versus Roth versus traditional IRA? - Are there tax-loss harvesting opportunities that can offset gains?
This kind of coordinated, year-round tax planning is one of the most valuable services that a well-coordinated advisory team can provide — and one of the most important topics we cover in MSFE's educational programs.