401(k) Withdrawal Strategies: The Art of Spending What You Saved

David retired at 62 with $1.2 million in his 401(k). Comfortable, he thought. More than enough.

For the first few years, he withdrew conservatively — just $40,000 per year to supplement his wife's part-time income. They were frugal. They barely touched the nest egg.

Then RMDs started at 73. By then, his account had grown to $1.8 million. His required withdrawal was $68,000 — more than he needed or wanted. Combined with Social Security, his income jumped to $110,000. His marginal tax rate climbed to 22%. Worse, 85% of his Social Security became taxable, and his Medicare premiums increased by $1,700 per year.

"I thought I was being smart by not withdrawing," David said. "But I was actually setting myself up for higher taxes later."

David's mistake is common. People think of 401(k) withdrawals as a threat — something to minimize. But the real art is in strategic withdrawals: taking the right amounts, from the right accounts, at the right times.

The rules that govern your access

Before you can strategize, you need to understand when and how you can access your money. The rules differ significantly depending on your age and circumstances.

If you leave your employer at 55 or older, you can access that specific employer's 401(k) penalty-free immediately. This is the Rule of 55, and it's more valuable than most people realize. The catch: it only applies to the 401(k) at the employer you just left, not old 401(k)s from previous jobs or IRAs you've accumulated elsewhere.

At 59½, the landscape opens up. You can withdraw from any retirement account — 401(k)s, IRAs, all of them — without the 10% early withdrawal penalty. You'll still owe income taxes on Traditional account withdrawals, but the penalty disappears.

At 73 (or 75 for those born in 1960 or later), the rules flip. Now you must withdraw, whether you want to or not. Required Minimum Distributions force a percentage of your balance out each year, growing larger as you age. Miss an RMD, and the penalty is brutal — up to 25% of the amount you should have withdrawn.

The penalty for withdrawing before 59½ is 10% on top of regular income taxes. A $50,000 early withdrawal could cost you $17,000 or more between taxes and penalties. But there are exceptions worth knowing: the Rule of 55, substantial equal periodic payments (72(t) distributions), medical expenses exceeding 7.5% of AGI, and permanent disability.

Why the conventional wisdom often fails

The standard advice sounds reasonable: withdraw from taxable accounts first, then tax-deferred accounts, then Roth. Let tax-advantaged accounts grow longer. Logical, right?

The problem is that this approach often creates a tax time bomb. By leaving Traditional 401(k) and IRA money alone during your early retirement years, you're allowing it to grow into ever-larger Required Minimum Distributions later. What was $1 million at 65 might be $1.8 million at 73. Instead of manageable withdrawals at low tax rates in your 60s, you're facing forced withdrawals at higher rates in your 70s.

David followed the conventional wisdom perfectly. He took from taxable accounts first. He left his 401(k) alone to "grow." The result was an 80% larger balance at RMD time — and correspondingly larger forced withdrawals that pushed him into higher brackets, triggered Medicare surcharges, and maximized his Social Security taxation.

The smarter approach recognizes that empty bracket space is a wasted opportunity. Those years between retirement and RMDs — often ages 62-72 — represent a window when your income is low and your tax brackets are accessible. Fill them.

The bracket-filling strategy

Tax brackets work like containers that fill from the bottom up. Your first dollars of income pour into the 10% bracket. Once it's full, additional income spills into the 12% bracket, then 22%, and upward. For married couples filing jointly in 2024, the 12% bracket holds income from $23,200 to $94,300 — a substantial range at a low rate.

The strategy is to deliberately fill those low brackets even when you don't need the money to live.

Picture a couple with $50,000 in Social Security and no other income. They're barely into the 12% bracket. The top of that bracket sits at $94,300. They have roughly $44,000 of unused space — room for withdrawals or conversions at just 12% federal tax.

If they withdraw $40,000 from their 401(k) and convert it to a Roth IRA, they pay about $4,800 in taxes. But that $40,000 is now permanently removed from the account that will generate RMDs later. Future growth happens in Roth, which has no RMDs. When they need money later, Roth withdrawals won't add to taxable income, won't make Social Security more taxable, won't trigger IRMAA.

Compare that to leaving the money alone. In ten years, that $40,000 has grown to $79,000 (at 7% returns). At age 80, they're forced to withdraw it plus more, potentially at 22% or higher, while also maxing out Social Security taxation and triggering Medicare surcharges.

The math overwhelmingly favors filling low brackets early.

The bucket approach to retirement spending

Beyond tax strategy, you need a system for managing volatility. Markets will crash at some point during your 30-year retirement. The question is whether you'll be forced to sell stocks at the bottom or whether you'll have other options.

The bucket strategy divides your portfolio into three pools, each with a different purpose and time horizon.

The first bucket holds cash and near-cash — high-yield savings, money markets, short-term CDs. This bucket covers one to two years of spending. Its purpose is to ensure you never have to sell investments in a down market. When stocks crash 30%, you spend from this bucket and wait.

The second bucket holds income-producing investments — bonds, bond funds, dividend stocks. This bucket covers three to seven years of spending. Its purpose is to refill the cash bucket during normal times and provide a secondary buffer during extended downturns. You draw from here to refill bucket one when markets are stable.

The third bucket holds growth investments — stock funds, equities, anything with long-term growth potential. This bucket funds your later retirement years. Its purpose is to grow faster than inflation and replenish the other buckets over time. You only touch this when it's up, never when it's down.

The system works by matching time horizons to volatility. Short-term spending comes from stable assets. Long-term needs get the benefit of equity growth. And market crashes — which are inevitable — don't force you to sell low.

The 4% rule and its limits

The classic guideline says to withdraw 4% of your portfolio in year one, then adjust for inflation each year. A $1 million portfolio generates $40,000. Raise it with inflation annually. In theory, your money lasts 30+ years.

The rule has served as useful shorthand for decades, but it has real limitations. It doesn't account for taxes — $40,000 from a 401(k) isn't $40,000 in your pocket after the IRS takes its share. It ignores sequence of returns risk — a market crash early in retirement is far more damaging than one late in retirement, even if returns average the same. It assumes rigid spending — most retirees don't spend the same amount every year regardless of what markets do.

More flexible approaches adjust for reality. The guardrails method increases withdrawals when your portfolio grows significantly (say, 20%) and decreases them when it drops significantly. You're not locked into a fixed amount while your portfolio value swings wildly. The floor-and-ceiling approach sets minimum and maximum withdrawal levels, providing flexibility without abandoning all discipline.

For early retirees facing potentially 40-50 year retirements, even 4% may be aggressive. A 3% or 3.5% initial withdrawal rate provides more safety for longer time horizons.

Minimizing the tax bite

Every dollar you keep from the IRS is a dollar that stays in your pocket or continues compounding. Several strategies legitimately reduce the tax burden on 401(k) withdrawals.

Tax bracket awareness means knowing exactly where your next dollar of income falls. If you're at $90,000 and the 22% bracket starts at $94,300, you have $4,300 of space at 12%. Use it. Don't accidentally spill into the next bracket when you could have stopped just below.

Strategic timing spreads large income events across years. If you need $100,000 for a home repair, consider taking $50,000 this year and $50,000 next year rather than all at once. You'll use two years of lower bracket space instead of one year of high bracket exposure.

Roth conversions during low-income years shift money from tax-deferred to tax-free. The taxes you pay now at 12% save you from paying 22% or higher later. This is especially powerful in the gap years between retirement and RMDs.

State residency matters more than most people realize. Nine states have no income tax at all. Several others exempt retirement income specifically. If you're retiring and have flexibility about where to live, the state tax implications of 401(k) withdrawals deserve serious analysis. The difference between California (13.3% top rate) and Florida (0%) on $80,000 in withdrawals is $10,640 per year.

The Medicare connection

Large 401(k) withdrawals don't just create income tax — they can trigger Medicare premium surcharges that add thousands to your annual costs.

Medicare IRMAA (Income-Related Monthly Adjustment Amount) kicks in at $103,000 for single filers and $206,000 for married couples filing jointly. Cross those thresholds, and your Part B and Part D premiums increase significantly. At the first tier above the threshold, a married couple pays about $2,000 extra per year. Higher tiers bring even larger surcharges.

The trap is the two-year lookback. Medicare uses your income from two years prior to determine current premiums. A large 401(k) withdrawal or Roth conversion in 2024 affects your 2026 Medicare costs. By the time you see the impact, you can't undo the income event.

This creates planning opportunities. If you're approaching Medicare eligibility, you might front-load conversions and larger withdrawals before you're subject to IRMAA. If you're already on Medicare, you might keep withdrawals just below IRMAA thresholds, using Roth accounts for additional needs since those withdrawals don't count toward MAGI.

Building your personal withdrawal plan

No single approach works for everyone. Your optimal strategy depends on your specific accounts, income sources, tax brackets, health, and goals.

Start by mapping all your income sources and their timing. Social Security — when you'll claim and how much. Pensions — guaranteed amounts with any COLA adjustments. Required distributions — projected RMDs at various ages. Investment income — dividends and interest from taxable accounts. And any earned income — part-time work, consulting, bridge employment.

Then identify the gap between that income and your spending needs. The gap is what you'll withdraw from savings. The question is which accounts to tap and when.

Optimize for taxes by projecting your bracket position year by year. Identify years with low income where aggressive 401(k) withdrawals or Roth conversions make sense. Identify years with high income where you should minimize additional taxable events. Consider IRMAA thresholds if you're 63 or older.

Build in flexibility for the unexpected. Markets crash. Health changes. Tax laws evolve. The best withdrawal plan adapts to circumstances rather than rigidly following a formula created years earlier.

David wishes he'd understood all this earlier. His decision to "leave the 401(k) alone" felt prudent at the time. A decade later, he's paying higher taxes than necessary on money he didn't need to withdraw.

The goal isn't avoiding 401(k) withdrawals — it's making them strategically, at the lowest possible tax rates, in service of a retirement that works for you.

Need help creating a personalized 401(k) withdrawal strategy? Connect with a retirement advisor who specializes in tax-efficient retirement income planning.