Which retirement accounts to draw from first?

Most retirees receive a retirement income from social security, investment accounts, employer-sponsored retirement plans, and individual retirement accounts. If you have multiple retirement accounts, you should figure out which retirement accounts to draw from first.

When you retire, you should withdraw funds from taxable assets first to take advantage of lower tax rates on dividends and capital gains. Next, withdraw funds from tax-deferred retirement accounts like 401(k), IRA, and 403(b). The last account you should draw from is the tax-free retirement accounts like Roth IRA so that they compound for as long as possible.

Order of Withdrawal from Retirement Accounts

Most investment advice suggests drawing retirement assets in the following order:

Taxable assets

Once you retire, the first account you should draw from is your taxable brokerage account, which is subject to taxes on dividends, interest, and capital gains. By withdrawing from taxable assets first, you allow your tax-advantaged retirement accounts such as IRA and 401(k) more time to compound.

Tax-deferred retirement assets

The second account you should draw from is your tax-deferred assets such as traditional IRA, 401(k), and 403(b) plans. These retirement plans allow participants to make pre-tax contributions, and the money grows tax-free until when it is withdrawn in retirement.

You can leave these retirement accounts untouched for as long as you want, and you won’t owe taxes until when you take a distribution. However, once you attain age 70 ½, you will be required to start taking the Required Minimum Distributions (RMDs).

Tax-free retirement assets

The last account you should draw from is the tax-free retirement accounts such as Roth IRA. Since a Roth IRA is funded with after-tax contributions, you won’t owe taxes on qualified Roth IRA distributions. Therefore, you can let the money compound tax-free for as long as possible while you draw from the taxable and tax-deferred assets. Since Roth IRAs do not have RMDs, you can delay taking distributions for as long as possible.

Withdrawal Strategies for Retirement Income

Depending on how much money you have saved for your retirement, you should decide on a withdrawal strategy that will ensure your retirement income lasts.

Here are common withdrawal strategies you can use:

The 4% rule

If you use the 4% withdrawal rule, you should withdraw 4% of your retirement income in the first year, followed by an inflation-adjusted withdrawal in subsequent years. When you use this strategy, your retirement income can sustain you for 30 years or more.  

For example, if you retire with $1 million in retirement savings, you can decide to withdraw $40,000 (4%) in the first year, but adjust withdrawals for inflation in subsequent years.

The advantage of this strategy is that withdrawals keep up with rising inflation, and your buying power remains consistent. However, this rule does not consider the performance of your investments, and with increased market volatility and inflation, there is a risk of running out of money before the end of retirement.

Fixed percentage withdrawal

This withdrawal strategy involves taking a fixed percentage withdrawal each year, regardless of inflation and market volatility. For example, if you decide to use 3.5% as your fixed percentage, you will withdraw 3.5% of your account balance every year over your retirement years. The withdrawals are automatically adjusted for market fluctuations.

However, with the rising interest rates and market volatility, the fixed percentage withdrawal strategy may result in income changes every year, which may be insufficient to maintain your buying power. Also, if you use a big percentage, you could exhaust your retirement savings a lot sooner.

Fixed dollar withdrawals

The fixed dollar withdrawal strategy involves withdrawing equal amounts of money each year for a certain period. For example, you can decide to withdraw $35,000 each year for the first five years, then adjust the withdrawal amount for the next period.

One advantage of this strategy is that you will have a predictable annual income, and you can budget the retirement income to cover your expected expenses. Also, it provides a reliable income in retirement, but it does not take into account the performance of the fund.

However, taking fixed dollar withdrawals has two risks. First, if your fixed withdrawals are too high, you risk exhausting your nest egg too soon before the end of your retirement. Also, if the fixed withdrawals remain unchanged for a long period, you risk losing buying power due to increased inflation and market volatility.

Limit withdrawals to Income

If you have saved a substantial amount for your retirement, you can decide to limit withdrawals to the incomes generated by the principal. You should allocate your retirement savings to various investments to earn interest and dividends.

The major benefit of this withdrawal strategy is that, if you have a significant nest egg, you can live off your investment income and leave the principal untouched for as long as possible. However, the annual income is unpredictable and will depend on market performance.