Most Retirees Are Making This 401(k) Mistake: Draining Taxable Accounts First

Many retirees hold most of their retirement wealth in pre-tax accounts such as 401(k)s and IRAs, with smaller portions in after-tax and Roth accounts. When withdrawals come from traditional accounts, the withdrawals are taxed as ordinary income, which can push retirees into higher tax brackets. Higher taxable income can also trigger Medicare IRMAA surcharges and reduce or eliminate preferential capital gains treatment on brokerage assets. RMDs can force withdrawals that exceed spending needs, creating taxable income retirees do not want. Withdrawal sequencing therefore has a major impact on total lifetime taxes, because it determines which accounts are depleted first and how much taxable income is generated over time.

"“What I see most of the time is that the pre-tax accounts, whether they're 401(k)s or IRAs, self-employment retirement accounts, that they're the dominating share of the tax type.” Her typical client breakdown is 60-70% in pre-tax accounts, 20% in after-tax, and 10% or less in Roth accounts. In the worst cases, “the pretax is 90% or more of a person's net worth, and that's going to create a big issue, especially if you're maybe a higher spender and especially when RMDs are due.”"

"Every dollar in a traditional 401(k) or IRA is taxed as ordinary income on withdrawal. Pull too much in a single year and you push yourself into a higher bracket, trigger Medicare IRMAA surcharges, lose the 0% capital gains rate on brokerage assets, and potentially owe the 3.8% Net Investment Income Tax. Lembcke is right, and the math is uglier than most retirees realize."

"“the way that they withdraw those funds, the sequence with which they withdraw the funds, has a huge impact on their total lifetime taxes” is arithmetic, plain and simple. Consider a 62-year-old couple with $2 million split 80/15/5 across traditional IRA, brokerage, and Roth. They need $100,000 a year to live. The conventional rule says drain taxable first, then traditional, then Roth."

"Following that order, they spend down the brokerage in roughly three years on capital gains taxed at 0% or 15%. Then at 65, they start pulling $100,000 a year from the IRA. That entire amount is ordinary income, on top of Social Security. By 73, when RMDs kick in under current law, the IRA has compounded back near $2 million. The required withdrawal alone can exceed what they spend, forcing taxable income they do not need. That is the tax time bomb Lembcke describes."

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