Which Money to Spend First in Retirement

By Justin Pritchard, CFP®

When you stop working, you may have several different accounts available to fund your spending. But which accounts should you withdraw from first, and why does it even matter?

How you spend from retirement savings can affect your taxes and other costs in retirement. So, it’s critical to use some strategy once you start drawing down assets.

Highlights:

  • The accounts you spend from affect your taxes.
  • Pre-tax, Roth, and taxable accounts have different features.
  • Conventional wisdom might not be the best way to draw funds.
  • By strategically taking income, you might improve things later in life.

Continue reading below, or get similar information from this video.

Types of Accounts

First, it’s crucial to understand the typical accounts a retiree can spend from. You might have savings in some or all of the following:

  • Pre-tax accounts
  • Roth-type accounts
  • Taxable or nonqualified accounts

You may use other terms to describe your savings, but most retirement savings vehicles fall into those categories. An exception might be “after tax” accounts, which may include a combination of after-tax and pre-tax money.

Pre-Tax Accounts

For most people, the majority of retirement savings are in pre-tax accounts. These assets might include:

  • 401(k), 403(b), TSP, and 457 plans
  • Traditional and rollover IRAs
  • SEP and SIMPLE plans
  • Lump sum pension assets

Note that it is possible to have Roth money in those plans as well. For now, we’ll focus on the pre-tax side of those plans, which is where many people (and their employers) add money during working years.

Pre-tax accounts provide a tax benefit when you contribute. You generally lower your taxable income, resulting in less tax due for the year you contribute. Plus, any earnings in the account do not have an immediate impact on your taxes—the tax is generally deferred.

But there is a tradeoff. When it comes to retirement accounts, you generally pay taxes sooner or later. In the case of pre-tax savings, you’ll pay later. Taking funds out of a pre-tax retirement account typically increases your income.

Note that direct transfers between pre-tax retirement accounts may not be taxable “distributions.” For now, we’re focusing on when you move that money into your bank account or into other taxable accounts. But it’s important to know that you can consolidate multiple pre-tax accounts into a single account.

Distributions from pre-tax retirement accounts are generally treated as ordinary income. That income is similar to earnings from a job or interest in your bank account. The more you have, the more tax you typically pay.

Roth Accounts

Roth accounts can potentially provide tax-free income.

Unlike pre-tax accounts, these savings do not offer an immediate income tax benefit when you contribute to the account. But if you satisfy all IRS requirements, you can potentially take funds out without owing any additional income tax. That includes your own contributions plus the earnings in your account.

You can accumulate Roth funds in several places, including:

  • Roth IRAs
  • Roth 401(k), 403(b), TSP, and 457
  • (Potentially) Roth SIMPLE and SEP

Roth money can be especially useful in retirement. Taking distributions from those accounts won’t raise your taxable income (assuming you qualify for tax-free withdrawals), so those funds can be handy when you’re cutting things close.

Like pre-tax accounts, Roth accounts offer tax deferral on year-by-year earnings in your account.

Taxable Accounts

Taxable accounts are standard accounts that do not have any retirement tax benefits. You can add as much as you want to these accounts (there are no annual limits), and you can withdraw funds at any time.

Because they lack retirement features, these accounts can create unwanted taxable income every year. Any interest or dividends you earn typically flow through to your tax return. And when you sell assets at a gain, you may also face capital gains taxes.

For most people, taxable accounts are individual or joint accounts.

Which Account Should You Spend First?

Once you stop working, you need to use your savings and investments to create income. The good news is that you might have some control over how much taxable income you get. The bad news is that you need to figure out the best way to proceed, and that can be complicated.

Ultimately, no article or video can tell you exactly what to do each year. Developing a strategy requires looking at your holdings and making assumptions about the future. For now, you can learn about the impact of different actions so you can make some educated decisions.

Traditionally, the conventional wisdom was to:

  • Spend down taxable accounts first.
  • Then, draw from pre-tax accounts.
  • Reserve Roth funds for last.

Unfortunately, that’s not the best approach for most people.

To manage taxes and other costs, you need to get more strategic. Evaluate the impact of alternative withdrawal plans, and you can arrive at a decent solution.

Conventional Wisdom

The traditional solution allows you to minimize taxes in the early years of retirement. This strategy can be tempting because it intuitively makes sense to pay as little tax as possible whenever you have the option. Plus, your tax preparer might suggest it as a way to minimize your tax bill each year, and financial advisors often publish generic information suggesting this approach.

Unfortunately, you can only put off taxes for so long, and you might miss opportunities to withdraw at relatively low tax rates. Each year presents a window of opportunity to take income strategically, and you can make things worse by letting pre-tax accounts grow.

This approach is reasonable because it preserves Roth assets. For many people, it’s helpful to reserve those funds for later in life, and your heirs might prefer to receive Roth assets if that’s part of your plan.

We’ll discuss a more robust strategy below, but first, let’s review another popular approach.

Pro-Rata Withdrawals

Some people decide to take a portion of the money they need from all of their accounts. Instead of picking one, you spend from each proportionally (so the largest account provides the largest amount of money).

For example, assume you have the following assets:

  • $200,000 in pre-tax accounts
  • $100,000 in Roth
  • $100,000 in taxable

If you wanted $4,000 using a pro-rata strategy, you’d withdraw the following (ignoring taxes):

  • $2,000 from pre-tax
  • $1,000 from Roth
  • $1,000 from taxable

While it’s unscientific and there are probably better options, this approach is not the worst of your options. But it may cause you to use Roth money prematurely and forgo other tax planning strategies.

The Impact of Strategic Withdrawals

The best way to spend from retirement accounts is to plan your spending with taxes in mind. Each account has specific tax features, so it’s critical to take advantage of opportunities and avoid paying unnecessary costs.

A well-designed strategy can potentially save hundreds of thousands of dollars (or more) in taxes. Of course, the results depend on how much you have in various accounts, unknown future events, and other factors.

The goal is to spend from whichever account provides the best source of funds both today and tomorrow.

When you stop working, your income drops. For many people, that means you’re in a relatively low tax bracket, and it might make sense to take income during those years.

You can “take income” in a variety of ways, including:

  • Withdraw from pre-tax retirement accounts and spend the money.
  • Convert pre-tax money to Roth.
  • Sell assets in taxable accounts.

Withdrawing Pre-Tax Money

Perhaps the easiest way to strategically take income is to withdraw from pre-tax retirement accounts first. This might make sense if you need funds to support your monthly or annual spending.

For instance, you might take distributions from an IRA and use the money immediately.

The withdrawals you take get reported on Form 1099-R, and you’ll include that income on your tax return. By pulling that income forward into current years (instead of waiting for future years), you can potentially smooth out your income.

Example: Assume you have money in a pre-tax IRA, and you have cash in a bank account. Your bank savings will support your spending until you reach age 70, when you’ll begin Social Security.

If you spend the cash from your bank account first, you’ll have almost no income in the early years of retirement. Yes, you might get interest earnings and other forms of income, but your standard deduction might completely offset that income.

A chart of your income (with selected tax brackets included) might look like this:

Chart showing withdrawals from taxable account first in retirement

That might be the perfect solution, especially if you need to minimize income in the early years. For example, you might think it’s best to qualify for health care subsidies, and you need a low income to do so.

But what about pulling some of that income forward?

If you withdraw from your pre-tax IRA you might come out ahead.

Plus, you can take additional income by doing strategic Roth conversions—converting a portion of your pre-tax account to a tax-free Roth each year. If you convert, you can use cash in taxable accounts to pay the taxes, helping to maximize the amount that ends up in Roth.

Drawing from pre-tax accounts and doing Roth conversions might look more like this:

Chart of withdrawal strategy spending from pre-tax accounts first and partial Roth conversions

Is that an improvement? Maybe. But maybe not.

Ultimately, it depends on what you’re trying to do. For some people, this strategy reduces lifetime income taxes and brings other potential benefits.

Situations to Consider

By spending from pre-tax accounts, you can potentially improve things.

Withdraw funds while in a low tax bracket: If you have the opportunity to take income in low tax brackets today, you might be able to withdraw less in higher tax brackets later in life.

Use deductions: It’s a shame to let a standard deduction (or other deductions) go to waste. If your income is so low that you have zero taxable income, consider increasing your income.

Reduce the size of pre-tax accounts: The bigger your pre-tax accounts, the bigger your required minimum distributions (RMDs) will be later in life. That forced income can raise your taxable income to unwanted levels, causing several complications.

Manage Medicare surcharges (IRMAA): If your income rises above certain levels while you’re using Medicare, you may have to pay extra each month. You can potentially avoid this by keeping RMDs as small as possible.

Manage Social Security taxation: Your Social Security retirement benefit might or might not be taxable. In general, the more income you have, the more you should expect to pay tax on your Social Security. Up to 85% of that income could get added to your taxable income. So, managing your taxable income later in life might keep more of your benefit tax-free.

  • Tip: You can pair a withdrawal strategy with Social Security strategy. For example, if you delay claiming, your Social Security benefit increases while you spend down pre-tax assets. As a result, you might end up with a bigger benefit—and less taxation on that benefit. Learn how a Social Security bridge works.

Rising tax rates? If you’re concerned about higher tax rates in the future, you might prefer to pay at today’s known rates.

Surviving spouse? If you’re married, one of you will likely die before the other. The surviving spouse would then be in single tax filing brackets—but they will probably have a similar income. As a result, the survivor is more likely to pay at high tax rates, and other complications (IRMAA, for example) could arise.

There may be other reasons, as well.

When to Draw From Taxable or Roth

Adding to your taxable income doesn’t always make sense. In some cases, you might benefit from spending taxable or Roth funds.

Minimize income for health care costs: If you’re getting subsidies for health insurance, adding to your income can cause you to lose those benefits. It’s important to consider ACA credits, state programs, etc., as you plan your income.

One-off expenses: Some large expenses can have a high tax cost. If you’re already in high tax brackets for a given year, does it make sense to add to your income? For example, if you need a new vehicle or a new roof, it might make sense to tap taxable or Roth accounts.

Again, there may be other reasons not shown here.