A Retirement Nest Egg Needs a Smart Withdrawal Strategy, Not Just Strong Returns

Building retirement savings is only part of the challenge. The way you draw money out — and the order you choose — can greatly affect taxes, Medicare costs, and how much you actually have to spend.

For years, many Americans focus on one central retirement question: How much can I save? We put money into 401(k)s, contribute to IRAs, follow the markets, enjoy the up years and endure the down ones. Then retirement begins, and the question shifts to something very different: How should I take the money out?

I once spoke with a man who was proud of having outperformed the market for three decades. I congratulated him. Then he showed me his withdrawal plan, and my enthusiasm faded. He had built a race car and fitted it with bicycle brakes.

That example is not unusual. A financial statement is usually designed to show growth, not how effectively that money can be turned into income. Accumulation gets attention, but distribution shapes your day-to-day life.

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The balance shown on your statement is not always the amount you can safely spend.

Consider a retiree with $100,000 in each of three accounts: a traditional IRA, a taxable brokerage account and a Roth IRA. On paper, that adds up to $300,000. In reality, those balances do not all have the same spending value.

Every dollar withdrawn from a traditional IRA is taxed as ordinary income. In the 22% federal tax bracket, that $100,000 is closer to $78,000 of spending power before state taxes. In effect, part of that account already belongs to the IRS, even if the exact share has not yet been determined.

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In a brokerage account, only gains are taxed, and long-term gains receive favorable treatment — sometimes as low as 0% for retirees whose taxable income stays below certain limits. A Roth IRA, if rules are followed, belongs to you outright.

Think of the three accounts as orchards. One produces fruit that can be harvested tax-free. Another triggers a tax bill only when gains are realized. The third lets you defer taxation until the government eventually collects its share. Having all three creates flexibility. Knowing when to tap each one is what turns that flexibility into spendable income.

Withdrawal order matters

I once worked with a retired plant manager whose records were spotless. His strategy was to pull money from whichever account had the largest balance and keep things roughly even. It sounded simple, but it could have been costly. His mistake was not about investing; it was about withdrawal order.

The common rule of thumb — spend taxable money first, then tax-deferred money, then Roth assets — is not a perfect solution either. Applied rigidly, it can leave a retiree with very little taxable income in the early years, wasting lower tax brackets that may never come again, and then concentrating income later.

In many cases, a blended approach works better: withdraw enough from tax-deferred accounts each year to fill a lower bracket, and use taxable or Roth funds for the rest. The real question is not only how much to withdraw, but where that withdrawal should come from each year.

Don't confuse paying less tax now with paying less tax overall

One retiree I advised wanted to avoid taxable withdrawals early in retirement. For several years, his tax returns looked excellent. Then required minimum distributions (RMDs) began and were layered on top of Social Security and his pension. His taxes and Medicare premiums ended up higher than they would have been under the staged-withdrawal approach we had modeled. He had not erased the tax bill; he had simply delayed it and may have made it larger. He avoided the drizzle and ended up in a thunderstorm.

The storm can get worse. When one spouse dies, the survivor generally files as a single taxpayer, with brackets roughly cut in half while RMDs remain about the same. And traditional IRAs passed to adult children generally must be emptied within 10 years, often during the heirs' highest-earning years.

That is why the years between retirement and the start of RMDs deserve close attention. Once paychecks stop and Social Security may not yet have begun, many retirees find themselves in the lowest brackets they will see for decades. That can create a valuable window for planned withdrawals or partial Roth conversions. There is no single best sequence, and generating taxes for no reason is never the goal. The point is to evaluate the strategy across many years of returns, not just one.

Medicare can make tax decisions more expensive

Medicare Part B and Part D premiums rise at higher income levels through surcharges known as IRMAA, based on your tax return from two years earlier. The surcharges work like cliffs: go over a threshold by even one dollar and you owe the full surcharge for that tier. A retiree who takes an extra IRA distribution for a car, a kitchen remodel or a child's down payment may not feel the impact until two years later. Roth conversions count as well.

The lookback rule can also work in your favor. If your premiums are still being calculated from income earned in your final working years, you can ask Social Security to consider your current income by filing Form SSA-44 and citing a work stoppage.

A withdrawal changes taxable income. Taxable income can change Medicare premiums. Social Security can change taxable income. RMDs can affect both. One piece of the system moves the others.

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Social Security is part of the withdrawal strategy, too

People often ask about the best age to claim Social Security. That question cannot be answered well without seeing the rest of the retirement plan.

Up to 85% of benefits can be taxable. In certain income ranges, every extra IRA dollar can pull more of a benefit into taxable income, pushing the effective marginal rate above the stated tax bracket. Delaying Social Security while living on IRA withdrawals can help in several ways at once:

• It reduces the account balance that will later drive RMDs.
• It replaces fully taxable IRA income with benefits that are at most 85% taxable.
• It secures a larger monthly payment: 8% more for each year you delay past full retirement age, up to age 70. A surviving spouse can keep the larger benefit if it is the higher of the two.

Delaying is not the right move for everyone; health and cash needs matter. Still, it shows why claiming Social Security and taking withdrawals should be treated as one coordinated decision rather than two separate ones.

The bottom line

Retirement income works best when you stop asking, “How can I pay the least tax this year?” and start asking, “How can I manage taxes across my entire retirement — and across my spouse’s and heirs’ lives as well?”

You do not necessarily need a more complicated plan. You need a coordinated one, created before withdrawals become mandatory and reviewed each year. After decades spent building the race car, do not wait until retirement to think about the brakes.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.