How to Create a Tax-Efficient Retirement Income Plan

Retirement income planning is about more than determining how much money you can withdraw from your savings each year. The source of that income can make a significant difference in how much you actually get to spend.

Two retirees with identical investment portfolios can potentially have very different after-tax incomes depending on which accounts they withdraw from, when they make those withdrawals, how much taxable income they create and how their withdrawals interact with government benefits and other income.

That is why a tax-efficient retirement income plan should consider the entire retirement timeline rather than simply following a fixed rule such as withdrawing a certain percentage from every account.

If you have not already read it, start with How Taxes Affect Your Retirement Plan and Financial Freedom . That article explains why taxes need to be included in the retirement plan from the beginning. This article goes one step further by looking at how you can organize withdrawals to potentially increase your after-tax retirement income.

What Is a Tax-Efficient Retirement Income Plan?

A tax-efficient retirement income plan determines how much income you need, where that income should come from and when to take it from different accounts.

The goal is not necessarily to pay the least amount of tax in every individual year. The goal is to make good decisions across your entire retirement.

Sometimes paying additional tax today can reduce a larger tax bill later. In other situations, deliberately keeping taxable income lower can preserve valuable tax brackets or help avoid unwanted interactions with government benefits.

The best strategy depends on your personal circumstances.

Why Withdrawal Order Matters

Many retirees have several different types of accounts, including taxable investment accounts, tax-deferred retirement accounts and tax-free accounts.

These accounts do not necessarily have the same tax treatment. Consequently, withdrawing $20,000 from one account can have a very different effect on your tax bill than withdrawing $20,000 from another.

This creates an important retirement planning question:

Which account should provide the next dollar of retirement income?

The answer may change throughout retirement.

The Three Broad Types of Retirement Accounts

Although account rules differ between Canada and the USA, it is useful to think about retirement assets in three broad categories.

1. Taxable Accounts

Taxable accounts generally contain investments that do not receive the same tax deferral or tax-free treatment as dedicated retirement accounts.

Depending on the country and investment, income may include interest, dividends, capital gains or other taxable amounts.

These accounts can be particularly useful for retirement income because withdrawals themselves may not be treated in the same way as withdrawals from a tax-deferred retirement account.

However, selling investments can create taxable gains, so the tax consequences of each withdrawal still need to be considered.

2. Tax-Deferred Accounts

Tax-deferred accounts generally allow money to grow without current taxation on every dollar of investment growth. Taxes are generally paid when money is withdrawn, subject to the rules of the specific account and country.

Examples include traditional IRAs and many 401(k) accounts in the USA, as well as RRSPs and related retirement income accounts in Canada.

These accounts can be extremely valuable, but their tax treatment means that the timing and amount of withdrawals matter.

3. Tax-Free Accounts

Tax-free accounts can be particularly valuable because qualifying withdrawals generally do not create the same taxable income as withdrawals from tax-deferred accounts.

Examples include Roth IRAs in the USA and TFSAs in Canada.

Having tax-free assets available can provide valuable flexibility when taxable income is already high.

There Is No Universal Withdrawal Order

A common retirement planning recommendation is to withdraw from taxable accounts first, then tax-deferred accounts, and finally tax-free accounts.

That approach can make sense in some situations, but it should not automatically be treated as the optimal strategy.

The reason is simple: retirement taxes are dynamic.

Your taxable income can change as you age. Employment income may disappear. Pension income may begin. Social Security, CPP or OAS may begin. Required withdrawals may eventually apply to certain accounts. Investment income can change. A spouse may die. Housing expenses may change.

A withdrawal strategy that looks efficient at age 60 may not be efficient at age 75.

That is why tax-efficient retirement planning should look at the entire projection rather than optimizing one year at a time.

Understand Your Taxable Income

One of the most important concepts in tax-efficient retirement planning is the difference between cash flow and taxable income.

Suppose you need $70,000 to spend during a particular year. That does not necessarily mean you need $70,000 of taxable income.

The amount of taxable income created depends on where the money comes from and the tax rules that apply to each source.

This is one reason a retirement plan should not simply project a single annual withdrawal percentage. It should track the tax consequences of the withdrawals.

Use Tax Brackets Strategically

Tax brackets are another reason withdrawal timing matters.

If your taxable income is relatively low during one period of retirement, you may have an opportunity to withdraw or convert money from tax-deferred accounts while remaining within a relatively favorable tax range.

Conversely, taking a large withdrawal in a year when you already have substantial taxable income can push additional income into higher tax brackets.

This does not mean you should avoid higher tax brackets at all costs. A larger withdrawal may still be the right decision if it improves your overall retirement plan.

The important question is not simply:

How much tax will I pay this year?

It is:

How does this decision affect my total after-tax retirement income over time?

Tax-Deferred Accounts Can Create Future Tax Obligations

Tax-deferred retirement accounts are powerful savings vehicles, but deferring tax does not necessarily mean eliminating it.

A large traditional IRA, 401(k), RRSP or similar account can create significant taxable income later in retirement when withdrawals are required or when you choose to take them.

This creates an important planning opportunity.

Rather than waiting until later retirement to discover that tax-deferred balances have become difficult to manage, you can model different withdrawal strategies years in advance.

In some circumstances, deliberately drawing down a tax-deferred account earlier can reduce future taxable income. In other circumstances, preserving that account can be more beneficial.

The correct answer depends on the complete retirement plan.

Roth and TFSA Accounts Provide Valuable Flexibility

Tax-free accounts can serve an important role in a retirement income strategy because they can provide spending money without creating the same type of taxable income associated with many tax-deferred withdrawals.

A Roth IRA can play this role for eligible U.S. retirees, while a TFSA can provide similar tax-free withdrawal flexibility for Canadians under the applicable rules.

Because these accounts can be valuable later in retirement, it may be tempting to preserve them indefinitely.

But preserving a tax-free account at all costs is not necessarily optimal either.

The purpose of retirement assets is to support your retirement goals. A tax-free account is a tool that can provide flexibility, not an account that must never be touched.

Consider Tax Planning Before Retirement

Tax-efficient retirement planning should begin before the day you stop working.

The years immediately before and after retirement can be particularly important because your income may change significantly.

For example, you may move from several years of high employment income to a period with substantially lower taxable income.

That transition can create opportunities to reorganize withdrawals, manage taxable income or evaluate conversions and other strategies where appropriate.

The specific opportunities depend heavily on your country, age, account types, income and future plans. Tax rules also change, so country-specific decisions should be reviewed using current rules and, when appropriate, qualified tax advice.

Government Benefits Can Change the Strategy

Retirement income does not come only from investment accounts.

Depending on where you live, your retirement income may include Social Security, CPP, OAS, pensions, rental income, employment income or other sources.

The timing and amount of these income sources can affect how much additional income you need from your portfolio.

They can also affect the tax consequences of additional withdrawals and, in some circumstances, the amount of government benefits you ultimately receive.

This is why tax planning cannot be separated completely from retirement income planning.

Our guide to CPP, OAS and Social Security explores how government benefits fit into the larger retirement picture.

Couples Have Additional Planning Opportunities

Couples may have additional options because retirement income can potentially be coordinated between two people.

The two spouses may have different account balances, pensions, employment income, government benefits and tax situations.

Consequently, simply withdrawing the same percentage from each person's accounts may not produce the best result.

Depending on the applicable rules, income splitting, pension allocation and coordinated withdrawals may help create a more balanced tax outcome.

The important point is that the household should be evaluated as a whole rather than treating each person's retirement independently.

Tax Efficiency Is Not the Same as Tax Minimization

This distinction is extremely important.

A strategy that produces the lowest possible tax bill this year is not necessarily the strategy that produces the highest lifetime after-tax income.

For example, deliberately realizing additional taxable income during a low-income year could increase your tax bill today while reducing future tax obligations.

Similarly, preserving a tax-free account may appear attractive, but using some of it could allow you to avoid an unnecessarily large taxable withdrawal elsewhere.

Tax efficiency means considering the interaction between taxes, income, investments, government benefits, spending and longevity.

Build Several Withdrawal Strategies

Instead of deciding on one withdrawal order and assuming it will remain optimal for 30 years, create several strategies and compare them.

For example, you might compare:

• Taxable accounts first
• Tax-deferred accounts first
• A blended withdrawal strategy
• Using tax-deferred withdrawals during lower-income years
• Preserving more tax-free assets for later retirement
• Using tax-free assets during high-tax years
• Different retirement ages
• Different government benefit start dates

The objective is not to find the strategy with the smallest tax bill in one particular year. The objective is to find a strategy that provides the retirement income you need while producing a sustainable and reasonable after-tax result.

Test the Plan Under Different Conditions

A tax-efficient strategy should not be evaluated only under one perfect set of assumptions.

What happens if investment returns are lower?

What happens if inflation is higher?

What happens if you live longer than expected?

What happens if you retire earlier?

What happens if one spouse dies earlier than expected?

What happens if spending changes significantly?

These are exactly the types of questions that should be explored before relying on a retirement income strategy.

Our article How to Stress-Test Your Retirement Plan explains why testing different conditions is such an important part of retirement planning.

How Retirementize Can Help

Retirementize is designed to help you look at retirement as a complete financial system rather than as a collection of isolated calculations.

You can model income, spending, investments, pensions, government benefits, housing and other retirement assets together and see how they interact over time.

Retirementize also accounts for taxes as part of the retirement projection, allowing you to see how different decisions can affect the income available to support your retirement.

Instead of asking only how much you have saved, you can explore questions such as:

• When should I retire?
• How much should I spend?
• Which income sources should I use?
• How might taxes affect my retirement income?
• Should I change my withdrawal strategy?
• What happens if I retire earlier?
• What happens if I live longer?
• How does a different spending target affect my plan?
• How resilient is my plan under different assumptions?

You can then use What-If scenarios to compare different decisions instead of assuming that your first plan is automatically your best plan.

This fits the broader Retirementize approach:

PLAN. IMPROVE. TEST. CONFIRM. REPEAT.

Tax-Efficient Retirement Planning Is a Long-Term Process

Your ideal withdrawal strategy can change throughout retirement.

The best approach at 60 may not be the best approach at 70. The best approach while one spouse is working may not be the best approach after both spouses retire. The best strategy before government benefits begin may change once those benefits become part of the household income.

That is why tax-efficient retirement planning should be treated as an ongoing process.

Start with a complete plan. Identify your sources of income and the tax characteristics of your accounts. Build several withdrawal strategies. Test them under different assumptions. Then revisit the plan as your circumstances change.

For a broader discussion of retirement withdrawal rates, read The NEW 4% Rule: Why You May Be Able to Spend More in Retirement .

A Practical Tax-Efficient Retirement Income Checklist

Before choosing a retirement withdrawal strategy, consider these questions:

1. How much after-tax income do I actually need?
2. What are my taxable income sources?
3. Which accounts are taxable?
4. Which accounts are tax-deferred?
5. Which accounts are tax-free?
6. When will pensions and government benefits begin?
7. Could my taxable income change significantly in future years?
8. Would taking additional tax-deferred income earlier improve my long-term position?
9. How should my spouse and I coordinate withdrawals?
10. What happens to the plan if I live much longer than expected?
11. What happens if investment returns are lower than expected?
12. Which strategy provides the best combination of income, flexibility and sustainability?

These questions connect directly to the broader retirement planning process. If you have not already done so, review Test Your Retirement Plan and How Taxes Affect Your Retirement Plan and Financial Freedom .

Tax-Efficient Retirement Income: Frequently Asked Questions

Should I withdraw from my taxable accounts first?

Not necessarily. Taxable accounts first can be a reasonable starting point, but the optimal strategy depends on your income, tax brackets, account balances, government benefits, spending needs and future taxes. A blended strategy may be better in some situations.

Should I spend my Roth IRA or TFSA last?

Not automatically. Tax-free accounts can be valuable sources of flexibility, particularly when taxable income is already high. Preserving them can also have estate-planning advantages in some circumstances. But using them can sometimes improve the overall retirement strategy.

Should I withdraw from my IRA or RRSP before retirement?

There is no universal answer. Lower-income years can sometimes create opportunities for tax-efficient withdrawals or conversions, but the decision depends on your specific tax situation, future income, account balances and applicable rules.

Is the goal to pay zero taxes in retirement?

No. The goal is to maximize the amount of money available to support your goals after taxes while maintaining a sustainable plan. Sometimes paying additional tax today can improve the long-term result.

Can a retirement calculator optimize my withdrawal strategy?

A retirement calculator can help compare different strategies, but the quality of the result depends on the assumptions and tax rules being modeled. A useful retirement plan should account for income, spending, investments, taxes, government benefits, inflation and longevity together.

Fun Facts About Retirement Taxes

Where This Article Fits in the Series

This is Article #14 in our financial freedom and retirement planning series.

You have already learned why taxes can materially affect your retirement plan in Article #13 . The next step is understanding how government benefits fit into the overall retirement income picture.

Continue with Article #15: CPP, OAS and Social Security: How Government Benefits Affect Retirement Planning .

You can also continue exploring the series through Article #12: The NEW 4% Rule , Article #17: Test Your Retirement Plan , Article #28: How to Stress-Test Your Retirement Plan , Article #40: Do I Need a Financial Advisor? , Article #41: Financial Advisor vs Retirement Planning Software , Article #46: 15 Questions to Ask a Financial Advisor About Retirement and Article #49: How to Use Retirementize With a Financial Advisor .

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