Once you start drawing down funds your investment accounts, you’ll need what’s called a withdrawal strategy. A withdrawal strategy determines how you take money out of your 401(k), IRA, Roth IRA, brokerage account and any other accounts and move that money into your checking account to spend from there.
Having an optimized strategy here can make the difference between paying 20% in taxes per year and paying zero taxes (which is also our plan).
There’s nothing shady about paying no taxes. We’re not opening up accounts in the Cayman Islands to hide our wealth, or converting it to Bitcoin so the government can’t track us.
This is the difference between tax-avoidance (bad, illegal, you can go to jail) and tax-optimization (math, legal, you can become a CPA with these skills).
Paying less in taxes means you get to keep more of your money. I don’t believe there’s anything noble or patriotic in paying needless taxes. If you disagree, then you can always optimize your taxes and still pay the government extra. I’m sure they won’t mind.
As for me, I’d rather have my money last longer and have more opportunities to do good with it – and my time.
Your Tax-Optimized Withdraw Goal
Your goal will be to craft a withdrawal strategy over the next 30 years that minimizes taxes for the long-term. In all honestly this is a math problem more than anything else.
Like with your asset allocation, your withdrawal strategy doesn’t need to be perfect. If you’re off a little here or there it’s OK! If you get the big parts right the little bits will take care of themselves.
An Example Withdrawal Strategy
Things are always clearer with an example. Let’s take a look at our final made-up-retiree: Bruce.
Bruce is 45 and about to retire early. He has $2,250,000 in the bank, with household spending of about $80,000 for a year. He’s run all the numbers based on his high-end yearly spending estimate and taxes and thinks he’s ready to start drawing down from his accounts:
- $1,250,000 in an IRA (which was a 401(k), but was rolled over after he left his last job)
- $250,000 in a Roth IRA (with deposits of $150,000)
- $500,000 in a brokerage account (with a cost-basis of $300,000)
- $250,000 in cash
Bruce’s asset allocation has shifted to a much more conservative 60% stocks / 40% bonds allocation to prepare for retirement. He plans to bump that back up to 70% stocks within the next year – which the portfolio should help out with naturally since stocks tend to outperform bonds).
Bruce should plan to withdraw $80,000 from these accounts in the first year, then $80,000 x 102% the second year to keep pace with inflation. His spending may not rise, but it’s better to take this into account and not need it than the other way around.
If you were Bruce’s advisor, how would you figure out what to do next?
There are a lot of routes to go with this and a lot of math to work out. We’re going to use a spreadsheet to help organize this:
Retire in Style Withdraw Strategy
Open up this spreadsheet and you’ll see the first “Personal Details” sheet matches Bruce’s description above.
So, where to start? Looking at Bruce’s account balances it’s clear that most of his money is in tax-advantaged accounts. Between his IRA and his Roth IRA, he has $1,500,000. He could use one of the early withdrawal strategies to access these, but let’s use that as a last resort.
Ideally, we’d want to withdraw from these accounts in this order:
- Cash
- Brokerage
- 401(k)
- Roth IRA
All the while refilling the cash bucket whenever we can.
Option 1: Cash Only
We don’t need a calculator to figure out that Bruce won’t be able to last for 15 years pulling money only from his cash accounts. The $250,000 he has saved up could last for 3 years, but that’s about it. He’ll have to take money from somewhere else to bridge the gap to age 60.
Option 2: Cash + Brokerage Only
The first real problem we have to solve is: Can Bruce’s brokerage account funds last until he’s old enough to withdraw from his 401(k)? Let’s model it out and see!
The first number we can work out is how much Bruce will get in dividends per year from his brokerage account. Every dollar in dividends is a dollar of stock he won’t have to sell.
Since his portfolio is tax-optimized, the entire $500,000 in his brokerage account is invested entirely in $VTSAX, our go-to US Index fund.
Checking out the Vanguard page for VTSAX, we can see that the dividend has been about 1.88% over the last 30 days. 1.88% x $500,000 = $9,400 a year! That means we only need ($80,000 – $9,400) = $70,600 more.
Side note: If you have multiple funds in your brokerage account, you can use this technique to estimate your total dividends.
Let’s break down how long his cash + brokerage money would last:
The cash bucket would last $250,000 / $70,600 or about 3.5. That’s assuming Bruce didn’t spend money from anywhere else.
The brokerage bucket is another story. It’ll heavily depend on the stock market – especially in the first few years. If the market drops by half that will radically change Bruce’s plans.
Since we don’t know what the market will do, we can instead plan for a constant 5% growth – but also have a backup in case the market drops.
If we knew the market would grow, the best solution would be to not withdraw any money in the first few years from his brokerage account. That’s time it could grow as well as more money coming from dividends.
After 3 years Bruce could switch from withdrawing from cash to withdrawing from his brokerage account. That might look something like this:
| Age | Spending | Dividend | Cash Withdraw | Brokerage Withdraw | Brokerage Balance |
| 45 | $80,000.00 | $9,400.00 | $71,728.00 | $0.00 | $500,000.00 |
| 46 | $81,600.00 | $9,870.00 | $72,914.40 | $0.00 | $525,000.00 |
| 47 | $83,232.00 | $10,363.50 | $74,112.12 | $0.00 | $551,250.00 |
| 48 | $84,896.64 | $10,881.68 | $0.00 | $74,014.97 | $578,812.50 |
| 49 | $86,594.57 | $10,034.28 | $0.00 | $76,560.30 | $533,738.16 |
| 50 | $88,326.46 | $9,096.66 | $0.00 | $79,229.81 | $483,864.77 |
| 51 | $90,092.99 | $8,061.97 | $0.00 | $82,031.02 | $428,828.20 |
| 52 | $91,894.85 | $6,922.89 | $0.00 | $84,971.97 | $368,238.59 |
| 53 | $93,732.75 | $5,671.56 | $0.00 | $88,061.19 | $301,678.55 |
| 54 | $95,607.41 | $4,299.58 | $0.00 | $91,307.82 | $228,701.29 |
| 55 | $97,519.55 | $2,797.98 | $0.00 | $94,721.58 | $148,828.53 |
| 56 | $99,469.94 | $1,157.11 | $24,313.00 | $64,625.00 | $61,548.38 |
| 57 | $101,459.34 | $0 | $0 | $0 | $0 |
| 58 | $103,488.53 | $0 | $0 | $0 | $0 |
| 59 | $105,558.30 | $0 | $0 | $0 | $0 |
| 60 | $107,669.47 | $0 | $0 | $0 | $0 |
There’s a lot going on here. Let’s focus on the major shifts:
Age 45-47: Bruce withdraws from his cash account only. During this time his brokerage account is growing and his dividends are going up slightly too.
During this time his only income would be from the dividends. For federal taxes, there is a standard deduction of $12,400 ($24,800 if filing jointly). Since his dividends are under $24,800, he ends up paying $0 in federal taxes for these years. He may still be on the hook for state taxes depending on where he lives.
Age 48 – 56: Bruce switches to his brokerage account for all withdraws – selling $VTSAX to pay for his yearly expenses. He’ll need to pay taxes on the capital gains from these, as well as the dividends.
In Bruce’s last year, he sold $94,721.58 in stock. How much tax will he have to pay on it?
That’ll depend on the cost basis of the funds. For Bruce, we’ll calculate that out to be a cost basis of $40,000. That means his capital gains are $54,721.58 with dividends of $2,797.98.
What’s always interesting to me is how his “income” is only about $57k, but he was able to spend almost $100k! This is one reason why having money in a brokerage account can come in so handy.
We can work out Bruce’s taxes for this year from most tax-inefficient (dividends) to most tax-efficient (capital-gains).
The first $24,800 earned will have no tax due to the standard deduction. This means all of the dividends are tax free as well as the first $22,002.02 of capital gains.
That leaves $32,719.56 of capital gains. What are the taxes on that?
| Filing Solo | Filing Jointly | |
|---|---|---|
| 0% | $0 to $39,375 | $0 to $78,750 |
| 15% | $39,376 to $434,550 | $78,751 to $488,850 |
| 20% | $434,551 or more | $488,851 or more |
You’re reading the table right – it’s 0%! You’d end up paying 0% taxes for every single year up until age 56!
Age 57 – 60: At age 57 we run into a problem. We’re out of money in your cash bucket and our investment bucket. It turns out it’s not going to be possible to make to age 60 using only these two accounts.
Option 3: Use the Roth IRA to Bridge the Gap
There are a bunch of options on how to bridge this gap – and many of them would still enable us to pay $0 in taxes. Here are what would consider to be the best two options:
The “easiest” way to bridge this gap until age 59 and half could be for Bruce to use his Roth IRA. You can withdraw the amount you put into a Roth IRA tax-free and penalty-free at any time.
Bruce could wait until his taxable account is depleted then rely completely on his Roth IRA, or he could start withdrawing some funds each year earlier on. Since he has $250,000 in this account at age 45, but 57 it could be double that! That’s plenty to bridge the gap and then live off the IRA from 60 on.
The Real Solution
The best-case solution is going to look a little messy. I’ll cut to the chase and list it out here then dissect it.
- First $24,000
- You’ll pay taxes on the dividends
- Convert $24,000 minus your dividends from your IRA -> Roth IRA conversion
- Roth IRA contribution
- Continue making a contribution of $6,000 (or $12,000 for Bruce and his partner) every year
- Withdraw the rest from cash, brokerage, and his Roth
Here’s the problem: if Bruce makes it to 60 but his taxable and Roth accounts are empty, he’ll be stuck paying taxes on his IRA withdraws every year from then out.
In the base case solution, we want to minimize tax for all of these years, not just those leading up to age 60.
Use the Roth IRA with a Roth Ladder Strategy
If you remember from the previous chapter, a Roth Ladder allows you to convert funds in your IRA to your Roth IRA then withdraw them at a later date – 5 years after the conversion.
The problem with a Roth Ladder is that you need to pay taxes at the time you convert your IRA to your Roth IRA. Worse yet, you’ll be taxed at your ordinary-income rate just like if you had a job!
If Bruce continues contributing to his Roth IRA while also rolling over money up until age 54, then by the time he’s 60 his Roth IRA will have almost $1 million dollars!
The “best case” solution surprisingly involves contributing even more to your Roth Ladder than the minimum. That’ll give you more money later to split between withdrawals in Bruce’s Roth and IRA.
The goal of all this is to reduce taxes. Sometimes 0% of taxes aren’t possible. The next best bet is to try to stay at the high end of the next tax tier up. Bruce should try to stay within the 10% tax bracket while converting money to his Roth IRA. Then once he starts withdrawing from his IRA, he’ll be able to also withdraw some from there – effectively lowering his taxes!
Calculate Your Withdrawal Strategy!
It’s time to give it a go! Try calculating out your own withdrawal strategy using your own numbers.
You may need to estimate out how much you’ll have in each account when you retire to plan for the following years.
Don’t worry about getting it right, but at least try to understand what strategies you’ll need to use. Will you need to use a Roth Ladder? Access your Roth accounts early? Does your plan require income coming in?
Once you have this strategy, you can continue to tweak it as you get closer to retirement!