Drawdown Sequencing: Considerations to Smarter Retirement Withdrawals

What is drawdown sequencing?

Stepping into retirement is often a much-awaited milestone. You finally get to live life more fully on your terms. However, flipping the switch from saving to actively spending your retirement funds introduces a complex new set of financial challenges and important questions. One of the first things you’re likely to ask is “Where should I take money from first?” Particularly as we live longer, and our retirements potentially grow in length, there are two primary concerns when you look at how to begin tapping into your retirement savings:

Sequence-of-returns risk: Markets and investments fluctuate over time, and a market downturn early in retirement can have a significant effect on how long your savings will last; particularly when you are withdrawing from your portfolio at the same time. Carefully managing this risk can help support the longevity of your retirement savings.

Tax planning: Pulling from different types of accounts can have different tax consequences. Considering which ones you use for retirement income each year can help you understand how withdrawals may affect your taxable income, tax bracket, and remaining savings.

Because everyone’s situation is different, we can’t provide specific tax advice in this article, but we will cover some of the key factors to consider, as well as examples of drawdown sequencing.

Traditional vs. proportional drawdown sequencing

A traditional approach has been to withdraw from taxable investment accounts first, tax-deferred accounts second, and finally tax-free accounts. The intent was to allow tax-advantaged accounts to grow as long as possible. But this approach may not be appropriate in every situation. There are a few potential considerations with this strategy. For example, relying heavily on tax-deferred accounts later in retirement could increase taxable income, particularly once required minimum distributions (RMDs) begin.

Proportional drawdown strategies are more complicated but also may provide greater flexibility in managing taxable income from year to year. Instead of draining one account bucket completely before moving on to the next, this strategy withdraws from multiple account types. This approach may provide greater flexibility to consider tax brackets, future RMDs, and liquidity needs together when planning retirement income. The guide and examples below illustrate considerations that may apply when using a proportional drawdown strategy.

Three buckets of retirement accounts

To build a withdrawal strategy, you first need to understand how different types of retirement savings are taxed. Most of your retirement savings fall into one of three primary tax buckets—each with its own rules and tax treatment.

Tax-deferred accounts like a 401(k)

Tax-deferred accounts, such as traditional 401(k)s and IRAs can represent a significant portion of retirement savings. Because contributions to these accounts may be made on a pre-tax basis, investments can compound and grow tax deferred. However, that tax deferral comes with a catch—in retirement, taxable distributions generally are included as ordinary income. If you lean on your 401(k) too heavily in a single year, additional taxable distributions could place some of your income in a higher marginal tax bracket.

Taxable investment accounts

This includes your standard investment accounts, mutual funds, and high-yield savings. These accounts are funded with money that was already taxed, but the tax treatment of withdrawals or sales depends on the type of asset and any income, gains, or losses involved. When investments are sold, any realized capital gains may be subject to capital gains taxes. Applicable tax rates depend on factors including the type of gain and your individual circumstances. This is usually among the more flexible and liquid sources of savings and can help you bridge gaps and address unexpected expenses.

Tax-free income accounts¹

These include but are not limited to accounts such as Roth IRAs, Roth 401(k)s, as well as certain investments that may generate tax-exempt income, such as municipal bonds. “Tax-free” refers to the future treatment of the assets, because the contributions have already been subject to income tax. Roth accounts are becoming more important in today’s retirement planning, particularly for higher-net-worth families. By paying taxes up front on Roth contributions, you may be able to take qualified distributions without including them in taxable income, subject to applicable requirements. This makes these accounts useful when managing taxable income while meeting retirement spending needs.

Honorable mention: Cash value life insurance²

Permanent life insurance policies, such as whole or universal life, offer more than just a death benefit for your heirs—they may also accumulate cash value over time. which generally are not treated as taxable income when taken, provided certain requirements are met. However, tax consequences may arise in some circumstances, including if a policy lapses or is surrendered with an outstanding loan. One thing to note is that accessing cash value will reduce the available cash surrender value and death benefit and may increase the risk that the policy will lapse.

Cash value life insurance can act as a potential source of liquidity during periods of market volatility. If the stock market declines early in your retirement, selling investments may lock in losses. Depending on your circumstances and available policy values, accessing life insurance cash value may be one alternative to selling investments during a downturn.

Step-by-step guide to drawdown sequencing

Executing a tax-efficient withdrawal strategy doesn't have to feel like advanced calculus. By following a clear, chronological process each year, you can review several important factors, including applicable IRS requirements, income needs, tax consequences, and available account types.

Step 1: Take any required minimum distributions

If you have reached the RMD age, you must calculate and take your required minimum distributions for the year from applicable retirement accounts, such as traditional 401(k)s and IRAs. Be sure to satisfy the full required amount, as failing to do so may result in an IRS excise tax.

Step 2: Balance your income needs with tax considerations

Once your RMDs are satisfied, consider those distributions along with other retirement income sources, such as Social Security, pensions, and annuity payments, and compare your total expected income with your annual spending needs. If your expected income doesn't cover your spending needs, you have an ‘income gap’ that needs to be filled from other accounts.

Step 3: Consider taxable accounts and tax consequences

To start filling that income gap, you may consider your taxable brokerage accounts, mutual funds, and high-yield savings. Selling investments in taxable accounts can result in capital gains or losses, depending on the asset's cost basis and sale price, but this tends to be lower than income tax. The tax consequences will depend on factors such as the type of asset, holding period, amount of gain or loss, and your individual tax circumstances. Using these assets first may also allow assets held in retirement accounts to remain invested, although whether that is appropriate will depend on your circumstances.

Step 4: Consider withdrawals from tax-deferred accounts

If you still need cash after drawing from your planned taxable funds, you may consider withdrawals from your tax-deferred accounts (like a traditional IRA) but consider how additional withdrawals may affect your taxable income and marginal tax rate. Your tax professional can help you evaluate the tax consequences of different withdrawal amounts.

Step 5: Consider applicable Roth withdrawal rules

When you need extra cash for a large, irregular expense—like a major home repair, a new car, or a dream vacation— a Roth IRA may be one potential source to consider as part of your overall withdrawal strategy. Qualified Roth IRA distributions generally are not included in gross income, while nonqualified distributions may have different tax consequences. Consider the applicable rules and consult your tax professional before making a withdrawal decision.

An example of coordinated drawdown sequencing

Consider this hypothetical example of a married couple, Mark and Sarah, who are both 68 years old. They’ve calculated that they need $90,000 this year to fund their everyday retirement lifestyle and a planned summer home project.

In the first scenario, they act without coordinating withdrawals from their accounts and withdraw the entire $90,000 from their traditional IRA. It seems like an easy solution, but the taxable portion of the distribution generally would be included in ordinary income. This could increase their taxable income and potentially cause some income to be taxed at a higher marginal rate, depending on their other income, deductions, filing status, and individual tax circumstances.

In the second scenario, they start by pulling $50,000 from that traditional IRA. This covers the bulk of their living expenses while limiting the amount withdrawn from their tax-deferred account. To cover more of their remaining needs, they pull $30,000 from their taxable brokerage account. This amount doesn’t count as ordinary income and is taxed by capital gains rules, based on the cost basis of the assets sold, the amount and type of any realized gain or loss, and their individual tax circumstances. Finally, to cover the $10,000 kitchen upgrade, they tap their Roth IRA. That final $10,000 generally would not be included in gross income if the distribution qualifies for tax-free treatment. By drawing from several different account types, Mark and Sarah create a different tax picture than they would by taking the full $90,000 from their traditional IRA. Their actual tax result would depend on their complete financial and tax circumstances.

This example is hypothetical and intended for illustrative purposes only and is not indicative of the actual performance of any particular financial product.

When to review or adjust your withdrawal strategy

Your financial life doesn't stand still, and neither should your withdrawal strategy. Tax laws shift, the stock market fluctuates, and your personal spending needs will naturally ebb and flow. Consider reviewing your strategy annually to recalibrate your bucket balances, adjust for market conditions, and assess whether your withdrawal approach continues to reflect your needs, goals, and circumstances.

Annual review checklist

If you’re still not sure how to plan for your retirement lifestyle, run through this brief annual checklist to recalibrate your withdrawal strategy, consider potential tax consequences and review your overall portfolio for the year ahead.

• Calculate your RMDs.
• Forecast your projected annual spending.
• Tally guaranteed income like Social Security, pensions, and annuity payments.
• Identify your net income gap.
• Consider how additional ordinary income could affect your marginal tax bracket.
• Review applicable Medicare income-related surcharge thresholds.
• Determine how you intend to cover your income gap across available income sources and accounts.
• Ensure you have a liquid cash buffer for emergencies.
• Rebalance your assets within and across accounts as needed.
• Consider whether a Roth conversion may be appropriate for your circumstances.
• Consider opportunities to harvest capital gains or losses, where appropriate.

Working with a financial professional

Retirement planning and withdrawal strategies can be complicated, and tax laws and individual circumstances can change over time. While it’s good to know the basics, working with a tax professional and qualified financial professional can help you evaluate withdrawal options in light of applicable tax rules, your financial goals, liquidity needs, and risk considerations.