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There is a relatively popular video where a person places rocks into a glass container. He begins placing large stones in the container until he can no longer place more. He then asks if the jar is full. When someone answers yes, he begins adding smaller stones around the bigger stones. Once he can no longer place smaller stones, he asks the same question. Is the jar full? When someone answers yes, he takes tiny pebbles and pours them into the jar until no more small pebbles will fit. Again the same question, Is the jar full? When someone answers yes he takes a container of sand and pours the sand into the jar. Once the container is full of sand, he stops and again questions the audience. Surely the container is now full? When someone answers yes, he produces a container of water and pours water into the larger jar. Once the container is full and can hold no more water, he looks at the audience and says that the container is now full!
This video causes viewers to question their initial assumptions, and fosters critical thinking “Outside the Box.”
It should also be noted that the instructor didn’t add sand or small pebbles first. If that sequence had been employed, there would be no room for the big rocks. The bigger rocks are placed first for the example to work properly.
When planning for retirement, and implementing those retirement plans, some “Big Rock” items should be addressed first.
Establishing a retirement plan, Social Security claiming status, securing retirement income for the first 3 to 5 years of retirement, and the proper distribution sequencing of retirement assets are some of these “Big Rock” items.
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This blog will discuss Distribution Sequencing, one of the Big Rock items.
During the accumulation years, workers place money in different accounts.
After-tax dollars are normally saved in brokerage accounts or savings accounts.
Before-tax dollars are normally placed in a tax-deferred account such as an IRA or a 401(k). People can place money into a Roth IRA and pay taxes at the time of the contribution.
These retirement accounts are divided into three sub-groups consisting of taxable accounts, tax-deferred accounts, and tax-free accounts.
Once income from work diminishes or ceases, these accounts are usually accessed to replace the lost work-related income.
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Does the Order in Which These Sub-Accounts are Accessed and Depleted Make a Difference?
The conventional approach to withdrawing retirement funds generally involves withdrawing from taxable accounts first, followed by tax-deferred accounts, and finally tax-free accounts. This strategy can minimize taxes and maximize the growth of tax-advantaged investments.
Does that mean that this is the best approach for everyone? Like most retirement-related topics, the answer is not a simple yes or no.
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Let’s explore some of the considerations using this approach:
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Taxable Accounts- First
These accounts, such as brokerage accounts or savings accounts are accounts where deposits have already been taxed, but income from balances is subject to taxes on capital gains and dividends. By withdrawing from these first, you can potentially offset capital gains with losses, reducing your tax burden. Additionally, you can benefit from a lower tax rate on capital gains compared to ordinary income. Taxes are generally lower on these accounts because only income is taxed. Taxes have been previously paid on the principal. Withdrawing from brokerage accounts first can assist in tax planning, as strategic Roth conversions or IRA distributions can be utilized to “top off” or fill existing tax brackets without increasing existing tax rates.
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Tax-Deferred Accounts- Second
Traditional IRAs, 401(k)s, and other tax-deferred accounts allow your investments to grow tax-free until withdrawal. Withdrawals are taxed as ordinary income, so using these after taxable accounts can help avoid paying higher taxes on initial withdrawals. The wisdom here is that depleting brokerage and savings accounts first will allow IRA balances to grow tax-deferred for the maximum amount of time. Distributions from IRAs are taxed as ordinary income and will increase total taxable income when added to income from brokerage and savings accounts. These tax-deferred accounts are subject to MRDs (Minimum Required Distributions) based on the age of the account holder. These MRDs are mandatory and based on the account holder’s age at the time of distribution. MRDs can diminish tax-planning capability because they are mandatory distributions. MRDs are taxed as ordinary income and MRDs increase every year based on the lifespan of the account holder. This can place the account holder in the uncomfortable situation of having additional taxable income and potentially higher tax rates, regardless of their wishes.
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Tax-Free Accounts- Last
Roth IRAs and other tax-free accounts offer tax-free growth and withdrawals, provided you meet the eligibility requirements. Leaving these accounts for last allows them to continue growing without being taxed, maximizing their potential for long-term investment. This is true! Leaving Roth IRA accounts intact and viewing them in isolation reduces the ability to use non-taxable Roth IRA dollars in tax planning. Roth IRA dollars can provide valuable “bridge” income between a person quitting working and before SSI benefits eligibility. Since Roth distributions are tax-free after meeting eligibility requirements, Roth distributions can add needed money to supplement other income sources without increasing taxable income. Roth distributions can be important in tax planning, IRA distributions, and tax bracketing. Roth distributions can also provide a tax-free source of income between quitting work and the beginning of Social Security benefits.
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Dynamic Withdrawal Sequencing
Over the last few years advisors have come to realize that Retirement withdrawals are not one-size-fits-all. Most advisors have come to view the distribution sequencing described above in much the same way as many advisors view Dave Ramsey’s Debt Snowball Method. Fully paying any debt is advantageous, but it may not be the most effective debt reduction method. Similar to the Debt Snowball Method, the sequence of depleting taxable, tax-deferred, and then tax-free accounts in that order may not be the most efficient or tax-effective order to deplete those accounts.
Most advisors find it more efficient to strategically withdraw money simultaneously from two or three types of retirement accounts to maximize income while most effectively utilizing existing tax brackets
Let’s look at a simple example: Retiree A is 67 years old, married, and needs an annual income of $90,000. He and his wife file taxes as (MFJ) Married Filing Jointly. Retiree A could withdraw $90,000 in principal from his brokerage account and pay zero taxes. Would that be the most efficient tax strategy? Because he is below the $96,700 ceiling for LTCG (Long Term Capital Gains), he could instead sell investments with large capital gains to fund his income needs realizing no taxes on the capital gains!
What happens if Retiree A begins receiving Social Security payments in the same year? $25,000 in Social Security income would raise his total income and now part of the long-term capital gains are subject to taxes. When filing their taxes, if he and his wife each claim a standard deduction of $16,550, his total taxable income will fall below the threshold for federal taxes.
Retiree A could also have taken the whole $90,000 from his Roth IRA account and avoided the above scenario since both principal and earnings are tax-free from eligible Roth IRA distributions.
It’s easy to understand how even a simple example can quickly become complicated.
There are too many moving parts to recommend the simple strategy of depleting taxable, tax-deferred, and Roth accounts in that order.
Filing status, current income tax brackets, standard deductions, other sources of income, capital gains treatment of income, IRA distributions, and social security income are some factors that will modify the distribution order and are most effectively mitigated by dynamic withdrawal sequencing.
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My simple example shows that the quickest and easiest ways to provide retirement income ignore the most tax-efficient strategy. Using a linear approach of depleting taxable accounts first discounts the benefits of withdrawing from several different accounts simultaneously to provide the greatest tax benefits.
In this example pressing the “Easy Button” could generate additional taxes of thousands or hundreds of thousands of dollars. These additional taxes could have been minimized or eliminated by better tax planning and dynamic withdrawal sequencing. This example also illustrates that there is no easy way for me to provide the best dynamic sequencing for all listeners.
At the beginning of the blog, I stated that the correct answer is different for each individual and family, and there are no blanket formulas that will work for everyone.
The Takeaway is that the easy way of linear account withdrawal is probably not the most tax-efficient way to withdraw from retirement accounts. The easy way will most likely generate additional tax revenue for the government, and less spendable income for the retiree.
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Other Factors to Consider:
Required Minimum Distributions: Participants are required to take RMDs from their tax-deferred retirement accounts. When RMDs become mandatory, they should be prioritized and withdrawals completed first to avoid potential penalties. RMDs from tax-deferred accounts can be mitigated through dynamic withdrawal sequencing by selectively distributing money from tax-deferred IRA accounts in the most tax-efficient manner before your RMD initiation.
Income From Other Sources: Most Americans will receive retirement income from the Social Security Administration. Some retirees will receive Pension income, rental income, or income from other sources. These additional income sources must be considered because all income, regardless of the source, will affect gross taxable income, and dynamic withdrawal sequencing.
Life Expectancy and Long-Term Needs: Your withdrawal strategy should consider your life expectancy and long-term financial goals. Charitable giving can be satisfied by using QCDs (Qualified Charitable Distributions). A QCD allows individuals 70½ years and older to make tax-free charitable donations directly from their IRA to a qualified charity. These donations can count towards an individual’s required minimum distributions (RMDs) if they are 73 or older, reducing their taxable income and potentially future RMDs. The maximum amount an individual can donate in a calendar year through QCDs is $108,000 in 2025. QCDs can be made from various IRA types, including traditional, rollover, SEP, and SIMPLE IRAs.
Funding of long-term care requires careful evaluation. How will long-term care needs be funded, where will the funding come from, and who will oversee finances if the account holder is no longer able to do so?
Personal Circumstances: Your tax bracket, investment mix, and overall financial situation should be evaluated and factored into your withdrawal strategy.
Legacy Giving: Does the individual or couple want to leave money to heirs? How will this affect dynamic sequencing? Will the individual or couple leave a Roth account untouched to provide the maximum benefit to heirs? Will there be funds left at the death of both spouses? What dynamic sequencing approach provides the maximum legacy amount for heirs?
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Final Thoughts
The older approach of depleting taxable accounts first, tax-deferred accounts second, and tax-free accounts last is probably the least efficient and most likely not the best approach for most retirees to utilize.
A more dynamic withdrawal sequencing approach has gained favor as it provides a more beneficial and tax-efficient approach to withdrawing from retirement accounts.
The dynamic withdrawal sequencing approach will likely save the greatest tax amount through strategic dynamic withdrawals.
There is no one-size-fits-all method that will work for all taxpayers. Each person or couple must carefully evaluate which dynamic sequence of withdrawals will work best.
Taxpayers with more complicated finances may want to seek out a financial advisor who specializes in retirement planning and retirement withdrawal strategies.
There are many factors to consider that alter withdrawal sequencing. Funding for long-term care or legacy goals means that dollars may be withheld or underutilized from certain accounts to fund these goals.
This is one area of retirement planning where I truly cannot provide an “easy button” for all readers as dynamic withdrawal sequencing is unique to each individual and Family.
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