Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / The Optimal Withdrawal Order for Early Retirees
Transcript
- Lucas: Let's say you're forty-five, retired for three years, and you've got a million dollars split across three accounts: a taxable brokerage, a traditional IRA, and a Roth IRA. Which account do you draw from first? Luna: Instinctively, I'd want to use the Roth—tax-free growth, right? But I suspect there's a catch. Lucas: Yeah, the instinct is usually wrong. The optimal order for most early retirees is: spend your taxable brokerage first, then your tax-deferred accounts like a traditional IRA, and finally your Roth IRA. And the reasoning is fascinating. Luna: Alright, I'm hooked. Why taxable first? Lucas: The short version: taxable accounts already have a built-in tax discount. You only pay capital gains on the growth, and if your taxable income is low—which it often is in early retirement—your capital gains rate can be zero percent. That's effectively tax-free withdrawals on the gains. Luna: So it's like a backdoor tax-free zone? But I'm guessing you lose that if you have other income. Lucas: Exactly right. And that leads into something we want to mention quickly. This show stays ad-free because of listener support. A small group of people chip in monthly at buy me a coffee dot com slash fexingo, and that's what funds making this many episodes. Luna: If our money conversations have helped you think about a decision differently, it's a simple way to keep them coming. No pressure, just a heads-up. Lucas: Now, back to that withdrawal order. The reason you don't want to start with your Roth is time. That Roth money can keep growing tax-free for decades—it's your most powerful asset for later in life. Luna: Makes sense. Let that compounding run as long as possible. Lucas: Right. And the reason you don't want to start with your traditional IRA is that those withdrawals count as ordinary income. If you pull from it early, you could push yourself into a higher tax bracket and also mess with the zero percent capital gains window. Luna: So taxable first keeps your income low, preserving that capital gains break for the taxable and setting you up for low-income years to do Roth conversions. Lucas: Bingo. That's the play. Spend from taxable in the first five to ten years of retirement. Keep your ordinary income low—maybe under the standard deduction plus enough to fill the ten percent bracket—and then use those low-income years to convert small chunks of your traditional IRA to Roth. Luna: But what if you have to pay for health insurance through the Affordable Care Act? Doesn't low income also mean bigger subsidies? Lucas: Great point. In fact, that's another reason to keep taxable income low. ACA subsidies are based on modified adjusted gross income. So if you draw only from taxable brokerage, your gains count toward MAGI, but you can control them by selling only enough to cover expenses. You can even use the zero percent capital gains bracket to maximize subsidies. Luna: So the strategy creates a virtuous cycle: low income, low taxes, high subsidies, and room for Roth conversions. Lucas: Exactly. Now, let's talk about the exceptions. If you've got a large traditional IRA and you're worried about required minimum distributions at seventy-three, you might want to start converting earlier, even if it means spending a little more from that account. Luna: Right. The order is a guideline, not a religion. There are trade-offs. Lucas: Another exception: if the market drops hard, you might want to draw from traditional IRA instead of taxable to avoid selling stocks at a loss. But you'd try to keep that income within the lowest bracket. Luna: What about the idea of using a 'bucket strategy' where you have cash for a few years? That's a different way to manage sequence risk. Lucas: Sure, and that's a good complement. Our episode on the bucket strategy covered that. But today we're talking about the order, not the source. The bucket strategy can still be applied to this order—taxable might be your short-term bucket, traditional IRA the intermediate, and Roth the long-term growth. Luna: Let's make it concrete. Give me a real example with numbers. Lucas: Okay. Let's say you're forty-five, retired, and you need $40,000 a year after taxes. You have $500,000 in taxable, $300,000 in a traditional IRA, and $200,000 in a Roth. You spend from taxable first. Suppose your cost basis is $300,000 in that account—so every dollar you spend has about forty cents of gain. If your total income is below about $47,000 for a single filer in 2026, your capital gains rate is zero percent thanks to the zero percent bracket. Luna: So you'd pay zero tax on that $40,000 withdrawal. Meanwhile, your Roth grows untouched, and you haven't touched the IRA. Lucas: Right. Then in years you have extra low income, you can convert say $20,000 from traditional to Roth, paying only about $2,000 in tax. Over ten years, you could move $200,000 into Roth, leaving your traditional IRA smaller when RMDs hit. Luna: So by the time you're seventy-three, your RMDs are manageable, and your Roth is huge and tax-free. That's the long-term win. Lucas: Exactly. The key is to start early and be intentional. One pitfall: some retirees spend from their traditional IRA first because they think 'deferring taxes is bad'—but that just piles up taxes later. Luna: I've seen that. People fear RMDs so much they pull from IRA early, then end up paying more tax over their lifetime. Lucas: Yeah, the math usually favors taxable first, then IRA, then Roth. But there's a nuance: if you have a very large taxable account with huge unrealized gains, and you're in a state with high capital gains taxes, you might prefer to defer gains by holding the taxable and spending from IRA. Unlikely for most early retirees, but possible. Luna: So the general rule is solid, but check your specific state tax situation. Lucas: Absolutely. One more thing: if you plan to leave an inheritance, the Roth is the best account to leave to heirs—they can stretch it tax-free. So preserving your Roth until later also helps your beneficiaries. Luna: What about someone who retires at fifty-five with a 401 still at their employer? That can change the order. Lucas: Good point. If you're fifty-five or older and leave your job, you can take penalty-free withdrawals from that 401 without rolling it over. That might make the 401 a better early source than taxable if you have a low balance and want to simplify. But the principle holds: spend from accounts that generate fewer ongoing tax benefits first. Luna: So taxable first, then tax-deferred, then Roth. Simple enough to remember. Lucas: Simple to remember, powerful to execute. The first few years of retirement are the most flexible—you have the most control over your income. Use them wisely. Luna: I think a lot of listeners will reconsider their withdrawal plan after this. I know I will. Lucas: That's the idea. Next time, we'll talk about how to sequence withdrawals when you have a mortgage or other debt in early retirement.