Schwab Intelligent Income: A Tax-smart Withdrawal Strategy

Retirees typically face several common questions when trying to figure out the best approach for taking withdrawals from their investment accounts for retirement income purposes due to the tax treatment of different types of accounts:

  • Which accounts should you withdraw from and in which order, to minimize the impact of taxes?
  • How much should you withdraw from each account type?
  • How will you know if your savings will last through retirement?

Conventional wisdom typically recommends taking withdrawals first from taxable accounts, then from tax-deferred accounts such as a 401(k) or traditional IRA, and finally from tax-exempt accounts such as Roth IRAs. (Keep in mind that Required Minimum Distributions (RMDs) must be taken from tax-deferred accounts beginning at age 70½ for people who reached that age in 2019 or beginning at age 72 for those who reached 70½ in 2020 or later due to the SECURE Act signed into law at the end of 2019.) This approach seeks to maximize growth in tax-advantaged retirement accounts by delaying withdrawals from them. As with many things in life, however, conventional wisdom regarding retirement distributions might not always be the best approach.

Rethinking conventional wisdom

Recognizing the potential drawbacks of conventional wisdom when considering the tax implications of RMDs1 and Social Security2, Schwab Intelligent Income™ uses a proportional distribution strategy for enrolled accounts to take withdrawals in the following order:

  1. RMDs
  2. Proportional withdrawals from both taxable and tax-deferred accounts
  3. Roth IRAs

This approach is based on research by Charles Schwab Investment Advisory, Inc. (CSIA) and the Schwab Center for Financial Research (SCFR) showing that taking distributions from both taxable and tax-deferred accounts in the same calendar year can help to better manage current and future tax brackets throughout retirement, leaving more money in your pocket after-taxes to enjoy retirement. A proportional withdrawal strategy also provides flexibility if tax rates or tax policy were to change again in the future. Leaving Roth IRAs until last maximizes the benefits of tax-exempt growth and provides flexibility in case a large lump sum withdrawal might be needed in the future and for purposes of legacy planning.

Why a proportional withdrawal strategy makes sense

Comparing the results of Schwab Intelligent Income's withdrawal strategy with a conventional approach illustrates why a proportional strategy can lead to better results. The example considers a 65-year-old individual planning for a 30-year retirement, receiving $27,000 annually in Social Security benefits and withdrawing $28,000 (total spending needs of $55,000) the first year from $600,000 of total retirement savings spread across three accounts: $150,000 in a taxable brokerage account, $400,000 in a traditional IRA and $50,000 in a Roth IRA. For this hypothetical example, RMDs begin at age 72.

For the first year, Schwab's tax-smart proportional withdrawal strategy automatically withdraws $7,636 from the taxable brokerage account and another $20,364 from the traditional IRA totaling $28,000 of withdrawals from their retirement savings. Nothing is withdrawn from the Roth IRA, allowing it to keep growing. In fact, assuming average market returns, no withdrawals would be required from the Roth IRA to meet spending needs over the full 30-year period. Figure 1 shows the withdrawals from each account over the 30-year period.3

Figure 1: Annual withdrawal amounts by account type

Source: Charles Schwab Investment Advisory, Inc.

Figure 2 shows the hypothetical results of the proportional withdrawal strategy of Intelligent Income vs. a conventional approach over the full 30-year period. As the chart shows, the estimated annual taxes grow each year with a conventional withdrawal strategy as a result of having a larger percentage of retirement savings held in a traditional IRA (leading to higher RMDs). By contrast, in Schwab Intelligent Income's proportional withdrawal strategy the estimated annual taxes start earlier in the withdrawal period, but grow at a slower pace and eventually decline in the later years. The result is cumulative estimated taxes over the 30-year withdrawal period of $132,490 for the conventional strategy vs. $106,769 for the tax-smart withdrawal strategy of Schwab Intelligent Income. That represents $25,722 less in estimated taxes in this hypothetical example, helping the retiree keep more money that can be used to enjoy retirement.4

Figure 2: Estimated annual taxes for different withdrawal strategies

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Source: Charles Schwab Investment Advisory, Inc.

Conclusion

The tax-smart withdrawal strategy of Schwab Intelligent Income is designed to overcome some of the drawbacks of conventional wisdom when it comes to retirement income. As demonstrated, a proportional withdrawal methodology can produce effective results when RMDs and Social Security are taken into account. Intelligent Income is designed to remove the guesswork in your retirement income planning and do the work for you in helping you plan, invest, distribute and monitor/adjust if needed, without penalty. That kind of confidence and control is what Schwab Intelligent Income is designed to deliver, so you can devote your time to focusing on fully enjoying your retirement.