Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How Early Retirees Manage Withdrawal Taxes
Transcript
- Lucas: So you've got a million and a half dollars spread across a taxable brokerage account, a traditional IRA, and a Roth IRA. You're retiring at fifty-two, and you need about sixty thousand a year before taxes. The question isn't just what to sell — it's what order to sell it in, because that choice can cost you or save you thousands every single year. Luna: And I'm guessing most people don't think about it that way. They just withdraw from whatever account is easiest. Lucas: Exactly. And that's a mistake. Because the order you take money from your accounts determines how much tax you pay this year — and how much your portfolio grows over the next twenty years. Let's break down the classic mistake first. Luna: What's the classic mistake? Selling from the IRA first? Lucas: Yeah, people often do that because it feels like they're 'using their retirement accounts' first. But every dollar you pull from a traditional IRA is ordinary income, taxed at your full marginal rate. For a couple with no other income in early retirement, that might be twelve percent. But if you're not careful, you can push yourself into the next bracket without realizing it. Luna: And that's where the order matters. Lucas: Right. So here's the better play. You want to use your taxable account first, then your traditional IRA, and save your Roth for last. Why? Because the taxable account only triggers capital gains on the growth — and if you've held the investments for over a year, those gains are taxed at long-term rates, which are lower than ordinary income. Luna: So in 2026, what are those rates for a couple? I know they've been adjusted for inflation. Lucas: Right. For a married couple filing jointly, the zero percent long-term capital gains rate applies up to about eighty-nine thousand in taxable income. That's after the standard deduction. So you can realize quite a bit of gains and pay zero federal tax on them. Luna: Zero percent. That's a huge incentive to use the taxable account first. Lucas: Absolutely. And here's the kicker — you can manage which specific lots you sell. This is called tax-loss harvesting in the bad years, but in the good years, you can choose to sell shares with higher cost basis first, minimizing your realized gains. So you have control over your tax bill. Luna: So what's an example with real numbers? Let's use that million and a half portfolio. Lucas: Okay, let's say you have six hundred thousand in the taxable account, five hundred thousand in a traditional IRA, and four hundred thousand in a Roth. You need sixty thousand a year to live on. Luna: And you're fifty-two, so no penalties, right? You can access the taxable account freely. Lucas: Right, the taxable account is completely flexible. The traditional IRA has a ten percent early withdrawal penalty before fifty-nine and a half, but you can do a Roth conversion ladder to get penalty-free access after five years. That's a whole other episode we did, but let's assume the money from the IRA is accessible without penalty. Luna: Okay, so how would you split the sixty thousand? Lucas: So first, you'd pull from the taxable account. Let's say you sell forty thousand worth of investments. Your cost basis might be twenty-five thousand, so you realize fifteen thousand in long-term gains. With your standard deduction, your taxable income is below the eighty-nine thousand threshold, so you pay zero percent on that. Luna: So you just got forty thousand tax-free, effectively. Lucas: Exactly. Then you need another twenty thousand. You take that from the traditional IRA. That twenty thousand is ordinary income, but here's the thing — with the standard deduction, your taxable income is still low. You might owe twelve percent on some of it, but it's manageable. Luna: So the traditional IRA is the second source, and the Roth you leave alone. Lucas: Right. The Roth is your most valuable asset for tax-free growth, and you want to let it compound as long as possible. But there's a twist — and this is where it gets interesting. Luna: I was waiting for the twist. Lucas: So, in the early years of retirement, you might actually want to do the opposite of what I just said. Instead of avoiding the traditional IRA, you might deliberately convert some of it to a Roth, even while you're living off the taxable account. Because your tax bracket is artificially low right now. Luna: Ah, the Roth conversion ladder. But we covered that in a previous episode. Lucas: We did, but here we're focusing on the tax interplay. In 2026, the twelve percent bracket for a married couple goes up to about ninety-four thousand in taxable income. So you could convert, say, thirty thousand from your traditional IRA to a Roth, pay twelve percent on it, and still be within that bracket. That's a one-time tax hit now, but that money grows tax-free forever and you avoid higher taxes later. Luna: So you're not just withdrawing — you're strategically rebalancing your tax exposure. Lucas: Exactly. And this is the part that most people miss. They think in terms of accounts, not in terms of tax brackets. But the real game is to fill up your low tax brackets every year with either income or conversions, and then use the tax-free buckets when you're forced to — or when you have no other choice. Luna: So what about Social Security? If you're taking it later, that changes the math too, right? Lucas: It does. And that's actually a reason to do conversions early. Once you start Social Security, your income floor goes up, which can push you into a higher bracket. So the window between retirement and Social Security is your prime conversion opportunity. You want to use those years to move money from your traditional IRA to your Roth at low rates. Luna: But what if you're not comfortable with the idea of paying taxes now for a future benefit? Some people might prefer to just pay as they go. Lucas: That's a valid perspective, but look at the math. If you're in the twelve percent bracket now, and you think you'll be in the twenty-two percent bracket later — which is likely if you have a pension, Social Security, or required minimum distributions — then every dollar you convert saves you ten cents. Over a decade, that's significant. Luna: So we're talking about a potential tax saving of, what, five figures over a decade? Lucas: Easily. If you convert thirty thousand a year for ten years and save ten percent on each dollar, that's thirty thousand in tax savings alone. Plus the growth is tax-free. That's not chump change. Luna: So what about the annual tax-loss harvesting in the taxable account? How does that fit in? Lucas: That's a great point. In years when the market drops, you can sell losing positions to realize a loss, which you can use to offset gains or even up to three thousand of ordinary income. That's a way to reset your cost basis and lower future taxes. It's a little more advanced, but it's another lever in your tax optimization toolkit. Luna: So the idea is to think about your entire portfolio as one big tax system. Lucas: Exactly. And that's the mindset shift we want listeners to take away. You're not just 'withdrawing from your IRA' — you're choosing which tax bucket to draw from each year based on what's most efficient. Luna: That's really empowering. It's like you're running your own mini finance department. Lucas: And it's not that hard once you get the hang of it. You just need to do a rough projection of your income for the year, estimate your deductions, and then decide how much to pull from each account. You can do it on a napkin. Luna: Speaking of empowering, you know what else helps? Knowing that our conversations are ad-free and listener-supported. We don't have sponsors pushing products, and that's intentional. If these episodes help you think about your money differently, and you want to support what we do, you can buy us a coffee at buy me a coffee dot com slash fexingo. It's a small gesture that keeps our show independent and ad-free. Lucas: Yeah, it really does make a difference. Even a few dollars from listeners who find value here helps cover the costs of producing the show. And it lets us keep doing deep dives like this without worrying about advertisers. We appreciate anyone who chooses to support us. Luna: Absolutely. Now, back to the withdrawal order. You mentioned a napkin — what's the simplest way to start planning? Lucas: Start with three numbers: your projected spending, your taxable income for the year, and your standard deduction. Then, see how much room you have before you hit the top of the twelve percent bracket. That's your conversion space. Fill that with Roth conversions, and use the taxable account for the rest. Only touch the traditional IRA if you have no other choice. Luna: And what about the Roth? When do you ever touch that? Lucas: Ideally, never, until you're forced to by required minimum distributions or if you have a huge medical expense. The Roth is your ultimate tax shelter, so you want to let it grow as long as possible. But if you need more than your taxable income plus conversions, you can tap it, but that should be a last resort. Luna: So the priority order is: taxable, then conversions, then traditional IRA, then Roth. Lucas: That's the framework. But every year is different, and that's why you do this planning annually. Market returns, tax law changes, your spending — all of it shifts the optimal strategy. So it's not a set-and-forget thing. Luna: And with tax law changes possible in 2026, it's probably more important than ever to stay flexible. Lucas: Right. The Tax Cuts and Jobs Act provisions that lowered individual rates are set to expire at the end of 2025, so we're already seeing what happens in 2026. The brackets have been adjusted for inflation, but the rates themselves are scheduled to revert to the old, higher levels starting next year. So this year is your last chance to take advantage of the current brackets in some cases. Luna: Wait, so the clock is ticking on the current tax rates? Lucas: It is. If Congress doesn't act, the twelve percent bracket becomes fifteen percent, the twenty-two becomes twenty-five, and so on. So for early retirees, doing a Roth conversion this year could be especially valuable. You'd be paying a lower rate now than if you waited until next year. Luna: That's a crucial point. So talk to your tax advisor or do your own math before December thirty-first. Lucas: Exactly. And that's the kind of thing that can turn a good withdrawal strategy into a great one. It's not about timing the market — it's about timing your taxes. Luna: Well put. So for our listeners who are thinking about early retirement, what's the one takeaway you want them to remember? Lucas: The order matters. The sequence of your withdrawals can be worth more than the rate of return on your portfolio. It's a controllable factor, and it's often overlooked. Take the time to plan it, and you can keep more of what you've earned.