Retirement Withdrawal Strategy: Which Account to Tap First?

You Saved Enough for Retirement. Now Which Account Should You Spend First?

We recently had a joint party to celebrate the birthdays of my 5-year-old daughter and 91-year-old grandfather. We had a great time hanging out with everybody. My daughter got $5 in a birthday card and was very excited. That’s the first money she’s ever had of her own and she’s trying to figure out what to do with it. Should she spend it now? Or save it? (She’s definitely not saving it and most likely going to order a kid’s steamed milk at her favorite coffee shop.)

It got me thinking that, in a different way, those questions don’t completely go away as we get older.

For most of our working lives, the financial goal is pretty straightforward: save for retirement. We put money into a 401(k), fund IRAs, and build up a brokerage account to eventually have enough money to live off of when we are done working. Then, after spending 30 or 40 years of being told not to touch retirement accounts, suddenly it’s time to start withdrawing from them.

That brings up a surprisingly common question, and one that I heard in three different client meetings this week: Which account am I supposed to spend from first? It seems simple enough, but where you take money from can make a pretty big difference, especially when it comes to taxes.

The Same $50,000 Can Look Very Different

Imagine a recently retired couple that has $800,000 in a traditional IRA, $200,000 in a Roth IRA, and $300,000 in a taxable investment account. They also receive Social Security but need another $50,000 this year to cover their expenses. They have the money, now they just need to decide where to get it.

If they take the $50,000 from the traditional IRA, it’s generally taxable as ordinary income. That could mean a bigger tax bill and could also affect how much of their Social Security is taxable or what they pay for Medicare down the road.

If they take it from the Roth IRA, assuming it’s a qualified withdrawal, it’s tax-free.

Or they could sell investments in their taxable account. In that case, they would owe capital gains tax on the growth, not the entire $50,000 they take out. Depending on their income and how much the investments have grown, that could result in a much smaller tax bill.

Those three examples are all withdrawing the same $50,000 but have very different results. That’s why simply looking at your account balances doesn’t tell the whole story. A dollar sitting in an IRA isn’t necessarily worth the same as a dollar sitting in a Roth IRA or checking account after taking taxes into account.

Sometimes Using Your IRA Earlier Makes Sense

The general rule that most people have heard of is that retirees should spend taxable accounts first, then traditional retirement accounts, and save Roth money for last. That’s not necessarily bad advice, but it doesn’t work perfectly for everyone.

For example, let’s say you retire at 62 and decide to wait a few years before claiming Social Security. You may have a window where your taxable income is much lower than it was while you were working and potentially lower than it will be later in retirement.

Instead of avoiding your IRA during those years, it may make sense to intentionally take some money out while you’re in a lower tax bracket. After careful tax planning, you might also consider converting some traditional IRA money to a Roth IRA. This allows you to pay taxes on that money during a lower-income year rather than waiting until later in retirement, when Social Security, pensions, and required minimum distributions may all be coming in at the same time. For some retirees, those combined income sources can push them into a higher tax bracket than they expected.

Which Account Goes First?

The answer, as you may have guessed, is it depends. There isn’t one account that should always be used first. A good withdrawal strategy looks at your taxes, Social Security, Medicare, investments, insurance, and future required distributions to decide what makes sense each year. In the end, retirement planning isn’t just about answering the question of, “Did I save enough?”, it’s also about figuring out the best way to use what you worked so hard to save.