How to Save Taxes by Choosing the Right Retirement Fund Withdrawal Order

Why is the strategy of retirement fund withdrawal important?

Retirement fund withdrawal order is the sequence in which you withdraw money from different types of retirement accounts, such as post-tax, pre-tax, and tax-free accounts. Choosing the right retirement fund withdrawal order can help you save taxes and make your retirement savings last longer.

In this blog post, you will learn:

- Why retirement fund withdrawal order matters

- An example of a retirement fund withdrawal order that minimizes taxes

- How to customize your retirement fund withdrawal order based on your situation

Why Retirement Fund Withdrawal Order Matters

Different types of retirement accounts have different tax implications. 

For example:

- Post-tax accounts, such as checking or saving accounts and stock accounts, are funded with after-tax dollars. You do not pay taxes on withdrawals from these accounts, except for the capital gains from selling stocks.

- Pre-tax accounts, such as 401K and IRA, are funded with pre-tax dollars. You pay taxes on the entire amount of withdrawals from these accounts as ordinary income.

- Tax-free accounts, such as Roth IRA, are funded with after-tax dollars. You do not pay taxes on withdrawals from these accounts, as long as you meet certain requirements.

By choosing the right retirement fund withdrawal order, you can reduce your taxable income and pay less taxes. This can also affect your eligibility for certain tax credits and deductions, as well as your Medicare premiums.

An Example of a Retirement Fund Withdrawal Order that Minimizes Taxes

Let's look at an example of a couple who retired with $1,000,000 in retirement funds. They have the following types of accounts:

- Checking or saving account (Post-Tax Accounts): $50,000

- Stock account (Post-Tax Accounts): $400,000 (Investment principal $200,000 + Investment income $200,000)

- 401K, IRA (Pre-Tax Accounts): $450,000

- Roth IRA (Tax-Free Accounts): $100,000

They need $120,000 a year to cover their living expenses. How can they withdraw their retirement funds in a way that minimizes taxes?

Step 1: Withdraw the Standard Deduction Amount from Pre-Tax Accounts

The first step is to withdraw the standard deduction amount of $27,700 from pre-tax accounts, such as 401K and IRA. This amount is not taxable, because it is below the standard deduction threshold for married couples filing jointly in 2023.

Step 2: Create Long Term Capital Gains from Stock Account and Withdraw the Remaining Amount

The second step is to create long term capital gains of $89,250 from the stock account and withdraw $92,300 ($120,000 - $27,700). Long term capital gains are profits from selling stocks that have been held for more than one year. They have a lower tax rate than ordinary income and can be tax-free up to $89,250 for married couples filing jointly in 2023.

By doing this, the couple can withdraw $120,000 a year without paying any taxes.

Step 3: Repeat Step 2 until Exhausting Long Term Capital Gains

The couple can repeat step 2 until they exhaust all the long term capital gains from the stock account. This may take several years, depending on the performance of the stock market and the amount of investment income.

Step 4: Withdraw the Remaining Amount from Post-Tax Accounts

When the couple has no more long term capital gains, they can withdraw the remaining amount of $92,300 from post-tax accounts, such as checking or saving account or the stock account. They do not pay taxes on these withdrawals, because they are not taxable income.

Step 5: Withdraw from Tax-Free Accounts

After the couple withdraws all the money from post-tax accounts, they can withdraw from tax-free accounts, such as Roth IRA. They do not pay taxes on these withdrawals, because they are tax-free.

How to Customize Your Retirement Fund Withdrawal Order Based on Your Situation

The retirement fund withdrawal order above is just one example. The optimal withdrawal strategy may vary depending on your individual situation, such as:

- The timing of receiving social security benefits

- The amount and types of retirement accounts you have

- The tax brackets and rates in the year of withdrawal

- The expected inflation and return rates of your investments

- Your personal and financial goals and preferences

Therefore, it is advisable to consult with a financial planner or a tax advisor before making a decision. They can help you create a personalized retirement fund withdrawal plan that suits your needs and maximizes your tax savings.

Explore the links for more insights!

• How much Retirement Savings Do You Need?
• Understanding Social Security Benefits: A Comprehensive Guide
• The 4% Rule for Retirement Fund Withdrawals
• The Perfect Plan for Retirement Savings: 8 Key Elements for Employees
• The Ultimate Guide to Roth IRA vs Traditional IRA: Which One Will Make You Richer?