Should You Drain Brokerage Accounts First in Retirement?

A more balanced withdrawal strategy could help smooth taxes and boost after-tax retirement income.

Taking withdrawals proportionally from multiple account types can help reduce tax shocks in retirement. MK Lasek/Shutterstock

You may have heard that in retirement, you should draw down your brokerage account first to meet immediate needs, while giving your tax-advantaged accounts more time to potentially grow.

This traditional approach suggests you drain your taxable brokerage account first, followed by a tax-deferred account like a 401(k), and finally a tax-free account like a Roth IRA.

This strategy could offer many advantages.

When you withdraw money from a retirement account such as a traditional IRA or 401(k), you’re taxed on the entire withdrawal at your ordinary income tax rate.

But when you withdraw funds from a brokerage account, you’re only taxed on the capital gains. This is the amount the assets you’re selling have grown by. And if you’ve held these assets for more than a year, you’d face the preferable long-term capital gains tax rates. These rates are generally lower than ordinary income tax rates, which can be as high as 37 percent. Depending on your income and filing status, long-term capital gains tax rates are 0 percent, 15 percent, or 20 percent.

By tapping your brokerage account first, your tax-advantaged accounts like 401(k) and Roth IRA have more time to grow. By the time you tap into your Roth IRA, you could enjoy tax-free qualified withdrawals for the rest of your retirement.

But while all this sounds great in theory, you’ll want to acknowledge the risks you often don’t hear about.

When It Doesn’t Make Sense

If you’re retired but have yet to start collecting Social Security benefits, your taxable income would probably be at its lowest. This could give you the opportunity to fill up the lower tax brackets, 10 percent and 12 percent, with distributions from your traditional IRA or 401(k). If you were to withdraw the same amount later when you are already collecting Social Security, you might have to pay a higher tax rate on the distribution.

And here’s another major reason why you shouldn’t let your traditional IRA or 401(k) just sit.

When you turn 73, you need to start taking required minimum distributions (RMDs) from those accounts annually. It doesn’t matter if you need the funds or not. And RMDs are treated as taxable income. These withdrawals could be large enough to launch you into a higher tax bracket. They could even increase taxes on your Social Security benefits and trigger surcharges on your Medicare premiums.

But RMDs are calculated based in part on the balance of your account. So by shrinking the size of your tax-deferred account, you essentially reduce the size of RMDs down the road.

And keep in mind that you may need to take RMDs from multiple accounts. For example, each of your traditional 401(k)s would require its own RMD.

So what can you do to come up with a tax-efficient retirement withdrawal strategy?

You could consider making proportional withdrawals from all types of accounts.

Proportional Withdraws

With the proportional withdrawal strategy, you first analyze your total savings and determine what percentage of total savings each account type holds.

Here’s an example of a breakdown based on a hypothetical retiree with $500,000 in savings.

• Total savings: $500,000
• Taxable account: $200,000 (40 percent)
• Tax-deferred: $250,000 (50 percent)
• Tax-free: $50,000 (10 percent)

So if this retiree needs $50,000 a year in retirement, this is how much he’d withdraw from each account based on its percentage of total savings.

Taxable account: $20,000

Tax-deferred: $25,000

Tax-free: $5,000

This strategy could help you smooth out your taxable income over time. With the traditional approach of draining your taxable brokerage account first, followed by your tax-deferred and finally tax-free account, you’ll pay little-to-no taxes in the first year of retirement and then get hit with a major tax bump in the middle. And this may become a bigger burden once you cross into RMD territory.

But by taking proportional withdrawals, you’re also reducing your tax-deferred account balance and thereby RMDs over time.

The result could be lower overall taxes throughout retirement and higher lifetime after-tax income.

The Bottom Line

A popular retirement withdrawal method involves tapping your taxable brokerage account first, followed by your tax-deferred account, and finally your tax-free account. The idea is to give tax-advantaged accounts more time to grow while you potentially enjoy lower taxes at the beginning of retirement. But this strategy could hit you with a tax torpedo in the middle of retirement as RMDs come into play. By contrast, a proportional strategy could result in a more stable tax bill throughout retirement and, again, higher lifetime after-tax income.

Still, the best strategy for you ultimately depends on your unique financial goals and tax situation throughout retirement. So it can help to discuss these strategies with a qualified tax advisor.

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