Building a tax-efficient retirement income plan for clients

By Kelley C. Long, CPA/PFS

After decades saving for retirement, transitioning to spending down savings can be a huge shift in mentality for retirees, and one that many may look to their CPA financial planner for assistance in planning. Additionally, one of the biggest surprises that new retirees often face is how their taxes change upon leaving the workforce. For the average worker who has spent his or her adult life paying ordinary income tax via payroll withholdings, the shift to flat withholding rates combined with differing rules depending on the source of their income can leave many clients with an unexpected tax bill that first April after they retire.

Besides educating clients on how different sources of retirement income are taxed, being able to help them build an income plan in a tax-efficient way is a valuable service and can save everyone time, tax, and frustration in the future. Depending on the age when clients retire, along with the tax diversity of their retirement assets, the focus may not be on paying as little tax as possible in those early years. It's wise to take a long view of spending down assets from a variety of sources each year. Here are some key concepts to address.

Start with traditional retirement accounts

Many retirees forget that they can have at least $25,000 in tax-free income each year due to the standard deduction, so they avoid taxable withdrawals unnecessarily. Clients with large balances in traditional 401(k) and IRA accounts can spread out the taxation of those accounts by withdrawing at least the amount of the standard deduction (or anticipated itemized deductions, if higher) for that year.

This assumes that the client does not have other sources of taxable income such as a pension or rental income — if that's the case, then those numbers should be factored into this equation. The bigger goal here is to draw down these accounts in anticipation of required minimum distributions (RMDs), which often force taxpayers into higher tax brackets in their 70s and later.

Next look to realize some capital gains

For clients with taxable brokerage assets, the next step would be to realize capital gains in those accounts to take income up to at least the top of the 12% tax bracket, since those gains are tax-free as long as there is no other taxable income. Clients who don't need the proceeds of these gains can simply reinvest for a reset basis (beware of wash-sale rules, however, if you're also incorporating any losses).

Use cash savings

If a withdrawal from traditional retirement accounts plus any realized capital gains is not enough to cover income needs for that year, the next place to turn would be any cash held in savings accounts. These withdrawals aren't taxable and therefore won't increase taxable income. Also, with interest rates remaining low, this strategy can help clients to postpone claiming Social Security, enabling them to lock in a higher fixed payment (which may not be taxed if income is planned accordingly) in the future.

Reimburse prior medical expenses from an HSA

It should go without saying that any medical expenses should be paid out of any health savings account dollars that remain, which are tax-free, but if the client also engaged in what's often called the "shoebox strategy" by deferring HSA reimbursement of eligible costs in earlier years, that would be the next place for retirees to turn to plug any income gaps. For more on this strategy, listen to the PFP podcast titled "Unique and Under-Communicated HSA Benefits," or read Gramlich, "How an HSA Can Be Viewed as a Flexible Tax-Favored Investment," 53 The Tax Adviser 26 (April 2022).

Withdraw from Roth IRA or 401(k)

Since Roth IRAs do not have RMDs (but Roth 401(k)s do, so best to have clients roll any Roth 401(k) money into a Roth IRA before age 72) and are the most tax-efficient way to pass along wealth to subsequent generations, it should be the last account tapped in a tax-efficient withdrawal plan. This allows the investments to continue their tax-free growth and ideally be passed along tax-free to heirs.

Finally, fill up lower tax brackets with Roth IRA conversions

For clients with a sizable amount in a pretax 401(k) or IRA, performing Roth IRA conversions each year in order to "fill up" the lower brackets is an ongoing tax-diversification strategy that has the double benefit of lowering RMDs while also allowing them to increase the tax-free income bucket should needs ever exceed planned withdrawals in the future. If there's room to realize some taxable income, it's worth examining.

Factoring in Social Security

One reason the strategy outlined here works is that the need to draw down cash savings will eventually be replaced by Social Security, which enables the client to lock in a higher payment that will be taxed less than other income like IRA and 401(k) withdrawals, if at all.

An example

To demonstrate, let's assume a married couple, both over the age of 65 and enrolled in Medicare, have an annual planned income need of $55,000. They are already receiving $30,000 of Social Security, leaving a balance of $25,000 needed from various retirement savings sources.

As long as they keep their combined income to the $32,000 limit or lower, they can avoid having their Social Security taxed, so the goal will be to find sources of income that don't exceed that calculation. It's worth pointing out that for Social Security taxation purposes, the income limit is calculated by adding nontaxable interest plus 50% of the Social Security benefit to adjusted gross income (AGI) to reach the "combined income." For this couple, that would be AGI of $17,000 before they'd pay taxes on at least 50% of their benefit.

As such, they would first look to withdraw $17,000 from a traditional IRA or 401(k), leaving them with an income gap of $8,000. There may be several options to plug that gap:

  1. If there are any HSA dollars, they could reimburse themselves for their combined $3,500 Medicare premiums, tax-free.
  2. The remaining $4,500 could come from taxable savings, brokerage assets, or Roth accounts, unless there were additional qualified medical expenses that could justify further HSA withdrawals.

If they stop here, they've effectively achieved $55,000 in tax-free income for the year. Clients with larger balances in traditional retirement accounts may wish to perform Roth IRA conversions up to the top of the 12% tax bracket in order to reduce future RMD amounts while locking in a lower tax rate on those dollars today.

Taking the long view on paying taxes in retirement

These planning steps can work contrary to the instinct of many retirees, who often wish to avoid any retirement account withdrawals while trying to live on Social Security or nonretirement savings only, hoping to save retirement savings for unexpected expenses such as health care needs later in life. This strategy can lead to unnecessary taxation of savings in their 70s and beyond due to RMDs. Helping them to instead shift tax-deferred assets into tax-free buckets by spreading out the withdrawals over the years is the key to effective tax planning in retirement.

The AICPA Personal Financial Planning Section has resources to support planning for HSAs as well as other health care and retirement areas, including: Guide to Social Security Planning, Guide to Practical Retirement Planning, Tax-Efficient Draw Down Strategies, PFP Tax Bracket Management Chart, and The Roth Conversion Decision Chart.

Kelley C. Long, CPA/PFS, CFP, is a personal financial coach in Tucson, Ariz. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at

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