How to Efficiently Replace Your Income When You Stop Working
Last month, we covered Roth conversions and the importance of monitoring your tax brackets during periods of lower earnings, such as retirement or a temporary career break. Building on the theme of tax planning in your work-optional years, this month I want to talk about replacing your income when you stop working by answering this question: When it’s time to pay yourself from your portfolio, which account should you pull from first?
The sequence in which you draw down your accounts can significantly impact how much of your wealth goes toward living expenses versus how much goes to the IRS. Here is how I design tax-efficient withdrawal strategies with the primary goal of minimizing taxable income (less income means less taxes, a common client goal 😉):
🟢 1. Cash First
We generally start by spending down cash reserves.
Why: Cash withdrawals generate no new tax liability. Only the interest is taxed.
The Goal: Draining cash first allows your tax-sheltered retirement accounts to continue to compound and grow.
But how do I replace my cash reserves since I’m responsible and always have an emergency fund? More on that in a bit.
🔵 2. Taxable Accounts Second
Why: Investments held for over a year in a taxable brokerage account are subject to long-term capital gains rates (0%, 15%, or 20%) on only the profit that you make, which are much lower than ordinary income tax rates. It’s important to remember that the amount you paid for the investment is NOT taxable, only the gain when you sell it is taxed.
The Goal: Tapping taxable assets after cash allows your tax-sheltered retirement accounts to continue to compound and grow. (Are you seeing the strategy yet?)
🟡 3. Tax-Deferred Accounts Third (Traditional IRAs & 401k/403b)
Next, we pull from pre-tax accounts.
Why: Every dollar withdrawn from a Traditional IRA or 401k/403b is taxed as ordinary income. These dollars are usually taxed the most, which is why they are further down the line.
The Goal: Withdraw only enough to cover essential spending or meet Required Minimum Distributions (RMDs), keeping your taxable income low and avoiding higher tax rates or Medicare IRMAA surcharges.
🔴 4. Tax-Free Accounts Last (Roth IRAs and Roth 401ks)
We leave your Roth accounts untouched for as long as possible.
Why: Money inside a Roth grows 100% tax-free, and qualified withdrawals are 100% tax-free.
The Goal: Because this is your most powerful growth asset, letting it compound for an extra 10 to 20 years maximizes your long-term wealth and provides a tax-free legacy for your beneficiaries.
⚠️ Important Note for Early Retirees (Protecting ACA Subsidies):
If you retire before age 65 and rely on the Affordable Care Act (ACA) for health insurance, your withdrawal sequence requires extra precision. ACA premium tax credits are based on your Modified Adjusted Gross Income (MAGI). Pulling too heavily from pre-tax IRAs increases your taxable income, which can significantly reduce your insurance subsidies and make your healthcare more expensive. In these early retirement years, we often lean more on taxable accounts or Roth funds to keep your MAGI low while maintaining enough funds to do the things you want to do.
My Insight
There are always going to be exceptions to this sequence. You’ve probably heard me say several times, “What we decide to do in one year may not make sense from a tax perspective the very next year. We have to review this stuff each and every year.” The primary goal is usually to minimize taxable income, and we can accomplish that by pulling funds in a manner in which the tax impact is the lowest.
Now, back to that question: How do I replenish my emergency fund? One of the best ways to top up your cash bucket is by following this sequence. To take it further, here are some more specific questions to ask yourself for your taxable accounts:
Do I have investments that are trading at a loss? Consider selling them to bank the loss to offset other gains. From the sales proceeds, transfer what you need to top up your emergency fund.
Within each investment, do I have specific lots that may be trading at a loss? Consider selling those too. If you don’t know where to look for specific lots, ask me to show you during our next review meeting.
Consider setting dividends and capital gains to “Pay to Cash” rather than having them reinvested. You can transfer this cash to your cash reserve bucket (either a high yield savings account or money market fund). **For retirement accounts, make sure dividends and capital gains ARE reinvested.
If you are looking to IRAs or Roth IRAs to replenish your cash, let’s talk. Because of the tax consequences, it is best to review these things together before withdrawing from these accounts.
Quick Note: This content is purely for educational guidance and high-level strategy. It isn’t meant to be personal tax advice. I always suggest checking in with your tax professional before making moves to confirm they make sense for your unique situation. And collaborating with your tax professional is a great use of our time!
Talk soon,
Krystal
P.S. What am I reading this month?
P.P.S. When was the last time you reviewed your account beneficiaries? Go log in to your investment accounts and review your primary and contingent beneficiaries. Make sure they are up-to-date.
⚠️ Don't Forget Your Health Savings Account (HSA)!
HSA beneficiary designations are unique because of the taxation. If a spouse inherits a HSA, it remains tax-free. However, if a HSA passes to a non-spouse beneficiary, the entire balance becomes taxable to them as ordinary income in that year. So if you don’t want to stick someone with a big tax bill, consider naming an heir in a low tax bracket or a charity as a beneficiary.