Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / The Early Retirement Withdrawal Order That Saves Thousands in Taxes
Transcript
- Lucas: You retire at 45. You've got a million and a half spread across four accounts — taxable brokerage, traditional IRA, Roth IRA, and a health savings account. The question nobody tells you to ask is: which one do you pull from first? Luna: And the wrong answer can cost you six figures in extra taxes over a twenty-year retirement, right? Lucas: Easily. I've run the numbers for a hypothetical couple — let's call them Jen and Mike. Retire at 45, spend $60,000 a year, portfolio of $1.5 million. If they withdraw from the traditional IRA first, they're paying ordinary income tax on every dollar. Over twenty years, that's roughly $90,000 in extra federal tax compared to the optimal order. Luna: Ninety thousand dollars just because of the order? Lucas: Just the order. And that's before state taxes and before you factor in what that lost compounding does to your portfolio. Luna: Okay, so I'm guessing taxable brokerage first is the usual starting point. But I've also seen advice that says you should do Roth conversions early. How do those fit together? Lucas: That is exactly the tension. And if you're finding this kind of decision useful, by the way — the way these episodes stay ad-free is through listener support. People who get value from the show can toss a few bucks at buy me a coffee dot com slash fexingo. It's how we keep doing deep dives like this without sponsors. Luna: Yeah, it's a small way to keep the show independent. And honestly, the fact that we can spend ten minutes on withdrawal order without a commercial break? That's because of listeners who chip in. Lucas: Exactly. So back to Jen and Mike. The optimal order is actually four steps, and it depends on your tax brackets and your age. Step one: spend from your taxable brokerage account. That's the money you've already paid taxes on — you only owe capital gains tax on the growth, and if you've held positions for more than a year, the rate is zero percent up to about $94,050 of taxable income for a married couple in 2026. Luna: Right, so you can realize gains tax-free up to that limit. That's huge. Lucas: It is. And it keeps your ordinary income low, which matters for step two. Step two: once the taxable account is depleted or you need more than it can provide, start doing Roth conversions. Convert money from your traditional IRA into your Roth IRA, but only up to the top of the 12 percent federal bracket. Luna: Which for a married couple in 2026 is about $96,950 of taxable income, I think? So you can convert roughly $30,000 to $40,000 a year and pay only 12 percent on it, assuming you have no other ordinary income. Lucas: That's exactly the play. You're filling the low tax brackets with converted dollars. And because you're in early retirement, you have years before Social Security and required minimum distributions start. Those are the golden years for Roth conversions. Luna: But if you've already spent your taxable account, where do you get the cash to pay the tax on the conversion? That's the part I think people miss. Lucas: You don't pay the tax from the IRA itself — that would be a distribution and defeat the purpose. You pay from your cash buffer, or from a separate savings account. Ideally you've set aside a year or two of living expenses in cash or a money market fund precisely for this. Luna: Okay, so step one is taxable brokerage. Step two is Roth conversions up to the 12 percent bracket. What's step three? Lucas: Step three: once you've converted as much as makes sense — you don't want to push yourself into the 22 percent bracket — start withdrawing from the traditional IRA directly for living expenses. But here's the key: you only do this after you've exhausted your low-tax conversion space, and you keep your total ordinary income below the threshold that triggers higher Medicare premiums. Luna: That's the IRMAA surcharge, right? Income-Related Monthly Adjustment Amount. For a couple in 2026, it starts kicking in around $210,000 of modified adjusted gross income. Lucas: Right. So if you keep your income below that, you avoid the surcharge. That's a big deal because the surcharge can add hundreds of dollars per month to your Part B and Part D premiums. Luna: And step four? I assume that's the Roth IRA. Lucas: Exactly. Roth IRA is the last account you touch. Let it grow tax-free for as long as possible. You've already paid taxes on the contributions, and the earnings come out tax-free after age 59 and a half. If you retire at 45, you could have fifteen or twenty years of compounding before you ever touch the Roth. Luna: But what if you need more than the taxable and the conversions can provide? Like, what if your spending is $100,000 a year and your taxable account only covers $40,000? Lucas: Then you might need to skip a step. The order is a guideline, not a rigid rule. If you need more income, you may have to pull from the traditional IRA earlier, or even from the Roth — though ideally you avoid that. The point is to minimize the tax you pay over your lifetime, not just in a single year. Luna: There's also the HSA. Where does that fit into this order? Lucas: The HSA is a special case. If you have receipts for qualified medical expenses from years past, you can reimburse yourself tax-free at any time. So you could hold onto those receipts and use the HSA as a supercharged savings account — let it grow tax-free, and then in later retirement, withdraw for medical costs or even reimburse yourself for old expenses. But if you need cash, you can also use it for non-medical expenses after age 65, though then the withdrawal is taxed as ordinary income. Luna: So the HSA is kind of a wild card. You can slot it in anywhere depending on your medical spending and whether you have receipts. Lucas: Exactly. But the general rule: HSA last, after the Roth, if you can afford to let it grow. But if you have large medical bills early in retirement, it might make sense to use it sooner. Luna: What about the inheritance angle? If Jen and Mike plan to leave money to their kids, does the withdrawal order change? Lucas: It does, and this is a great point. If you want to leave a tax-efficient inheritance, you actually want to spend down the traditional IRA first, because your heirs will have to take required minimum distributions from inherited IRAs and pay tax at their own rates. Roth IRAs, on the other hand, pass tax-free. So if leaving a legacy is a priority, you might flip the order — spend traditional IRA money earlier, let the Roth grow for your kids. Luna: That's a really important nuance. Most withdrawal order advice assumes you're planning to spend every dollar yourself. But if you're building generational wealth, the math flips. Lucas: Exactly. And that's why I always say: there's no one-size-fits-all order. You have to model your own situation. But the four-step framework — taxable, Roth conversions, traditional IRA, Roth IRA — is a solid starting point for most early retirees. Luna: And if you're still in the accumulation phase, you can set yourself up for this by building up that taxable brokerage account. A lot of people go all-in on tax-advantaged accounts, but having some after-tax money gives you flexibility in early retirement. Lucas: Absolutely. A common mistake is to have all your savings in traditional IRAs and 401s. Then when you retire early, every dollar you withdraw is taxable ordinary income. You can't do Roth conversions because you have no cash to pay the tax. You're stuck paying 22 percent or more on everything. Luna: So the takeaway: before you retire, make sure you have at least a few years of expenses in taxable accounts or cash. That gives you the runway to do low-tax Roth conversions in your early retirement years. Lucas: Exactly right. And if you're already retired and haven't been doing this, start now. Even if you're 60 instead of 45, the same logic applies — you want to control your taxable income each year to stay in the lowest brackets possible. Luna: One more thing: the Medicare surcharge. A lot of people don't realize that Roth conversions count as income for IRMAA. So if you convert too much in one year, you could spike your Medicare premiums two years later. Lucas: That's a very real trap. The IRMAA lookback uses your tax return from two years prior. So if you do a big conversion in 2025, it affects your 2027 Medicare premiums. You have to plan ahead. Spread conversions out over multiple years to stay under the threshold. Luna: And if you have a year where your income is unusually low, that's a great year to do a conversion. Lucas: Exactly. Take advantage of the natural dips. Sell a rental property? Might push you into a higher bracket that year, so skip the conversion. Have a year with no other income? That's the time to convert aggressively. Luna: I think the biggest mindset shift for me was realizing that tax planning isn't just about minimizing this year's taxes. It's about managing your lifetime tax rate. The withdrawal order is one of the levers you can pull. Lucas: And it's a lever that most people ignore. They just withdraw from whatever account is easiest, or they take the required minimum distribution and call it a day. But if you're intentional about it, you can keep more of your money working for you. Luna: So for our couple Jen and Mike — retiring at 45 with $1.5 million and spending $60,000 a year — what does the optimal path actually look like in dollar terms? Lucas: Let's say they have $500,000 in taxable, $500,000 in traditional IRA, $400,000 in Roth, and $100,000 in cash. Year one, they spend $60,000 from the taxable account. They sell shares with a cost basis of $40,000 and gain of $20,000. Their taxable income: $20,000. They pay zero federal tax, because the standard deduction for a married couple in 2026 is about $30,000. So they're below the deduction. Luna: And they can also do a Roth conversion that year up to the top of the standard deduction, essentially converting tax-free. Lucas: Exactly. They could convert about $10,000 from traditional IRA to Roth and pay zero tax on it. So they're building their Roth while paying no tax. If they do that for ten years, they've moved $100,000 into the Roth tax-free. Luna: Meanwhile, the taxable account is being depleted, but the Roth is growing. And then when they hit 65, they have a large Roth that they can withdraw from tax-free for big expenses like healthcare or a new roof. Lucas: Exactly. And they've avoided the tax torpedo that hits when Social Security and required minimum distributions combine in their 70s. By keeping their traditional IRA smaller through conversions, they reduce future required minimum distributions and keep more of their Social Security benefits untaxed. Luna: This is one of those topics where the details really matter. But the core principle is simple: withdraw from the most tax-efficient account first, and let your tax-advantaged accounts grow as long as possible. Lucas: Simple to say, harder to execute. But if you take one thing from this episode: pull from taxable first, convert to Roth in the low-income years, and save your Roth for last. That order alone can save you tens of thousands. Luna: And if you're not sure about your own situation, there are free tools like the New Retirement or Boldin calculators that let you model different withdrawal orders. Lucas: Or you can do it old-school with a spreadsheet. The key is to run the numbers for your own circumstances. Because Jen and Mike's optimal order might not be yours if you have a pension, or a side business, or a different spending pattern. Luna: Alright, I think we've given listeners a solid framework to work with. Next time, maybe we dig into how Social Security claiming strategies interact with the withdrawal order. Lucas: That's a great follow-up. Because the decision of when to claim Social Security can change your tax brackets in later years, which feeds back into the optimal withdrawal order. We'll save that for another episode.