Your choice will have a big impact on your taxes. By Mary Beth Franklin, Senior Editor May 31, 2007 When it's time to tap your retirement savings, conventional wisdom dictates that you should first withdraw money from your taxable accounts. That allows your IRAs and other tax-deferred accounts to compound for as long as possible. "You never want to pay a tax bill today that you can postpone until tomorrow," says Rande Spiegelman, vice-president of financial planning for Charles Schwab.But even Spiegelman concedes that every rule has its exceptions. And sometimes it pays to split your retirement withdrawals between your taxable and tax-deferred accounts now to prevent a huge tax bill later. Retirement is also a good time to review how your investments are allocated among your taxable and tax-deferred accounts. You may be surprised to find that the investment strategies that worked well while you were saving for retirement could work against you when you start withdrawing your money. Investment swaps. There's a big difference between the way investments are taxed inside a retirement account and outside of one. When you hold an asset for more than a year, then sell it at a profit, you pay long-term capital-gains taxes at a maximum rate of 15% -- if the asset is held in a taxable account. Advertisement If that same asset is held in a tax-deferred retirement account, there is no tax consequence when you sell it. But when you withdraw the money from the account, all of it is taxed -- not just your profit -- at your ordinary income-tax rate, which could be as high as 35%. The 20-point spread between the maximum long-term-gains rate and the top ordinary income-tax rate can make a significant difference in your after-tax income during retirement. But most people have their investments in the wrong accounts when they retire, says Mark Cortazzo, head of the Macro Consultants financial-planning firm, in Parsippany, N.J. "People tend to hold most of their long-term-growth investments inside their 401(k)s and keep their Ôsafe money' in CDs and money-market accounts in taxable accounts," says Cortazzo. "That's fine while you're accumulating assets, but once you retire you're better off flip-flopping them." Let's say you have $100,000 invested in stock-index mutual funds inside your 401(k) and another $100,000 worth of certificates of deposit in your taxable account. When you retire and roll your 401(k) into an IRA, you could sell your mutual funds -- with no tax consequence -- and use the money to buy CDs or bonds. You would defer tax payments until you withdraw money from the IRA. At that time, the entire distribution, including the CD and bond interest, would be taxed at your ordinary tax rate -- the same rate you'd pay on the interest from the CDs if they were held inside a taxable account. But you'd save considerably in your taxable account by cashing in the CDs and buying the same index funds you once held in your 401(k). You'd create a whole new cost basis for the stock funds in your taxable account, and as long as you held the assets for at least a year before selling them, you'd be taxed at the maximum 15% capital-gains rate -- and only on your profits. In addition, you could use any investment losses in your taxable account to offset profits and reduce your overall tax bill -- something you can't do with investments in an IRA. Advertisement So just by swapping the location of your investments, you maintain your portfolio's asset mix and increase your after-tax returns without taking on any additional risk, Cortazzo says. Your money will also last longer because you won't have to withdraw as much from your taxable accounts each year to generate the same amount of after-tax income. (To get an idea of how to divide your assets among taxable and tax-deferred accounts, take the quick quiz at www.trivant.com/ira-tax-benefits.) Golden years. You are required to start withdrawing from your IRA by April 1 following the year you turn 70½, and to make withdrawals each year afterward. Your withdrawals are based on your account balance at the end of the previous year divided by your life expectancy, as determined by IRS mortality tables. But if you have a large IRA balance and wait until the deadline, your required distributions could be substantial, pushing you into a higher tax bracket. To save on taxes once you retire, you could start taking voluntary, penalty-free distributions anytime after you reach age 59½. Touch your money before age 59½ and you'll have to pay a 10% early-withdrawal penalty on top of the usual federal and state income taxes. But retirees between the ages of 59½ and 70½ enjoy a golden period during which they can withdraw as much or as little of their retirement funds as they choose -- and adjust their taxes accordingly. Advertisement In fact, like Norm and Cheryl Thomas of St. Charles, Ill., you may be surprised at how much you can control your tax bill by shifting the sources of your retirement income. Even though their income has approached six figures each year since Norm retired from a telecommunications manufacturing company in 2001, the Thomases seldom pay more than 15% in federal taxes and 3% in state income tax. That's because the bulk of their income comes from dividends and capital gains held in taxable accounts that are taxed at a maximum 15%. They supplement their investment income with a modest pension (exempt from Illinois taxes), Norm's Social Security benefits (only partially taxed) and some IRA distributions (fully taxed at ordinary rates). Three years ago, Norm, now 67, and Cheryl, 60, decided to use some of his IRA money to buy property in St. Georges, Utah, and they recently built a second home on the lot. By using the money in his IRA rather than his investment account, Norm preserved the couple's source of low-tax income for years to come, says his financial consultant, Michael Lantz, of A.G. Edwards. Tapping the IRA will also reduce the size of Norm's required IRA distributions once he turns 70½. Maximum tax breaks. John Barber, chief investment officer of TriVant Custom Portfolio Group, in San Diego, urges retirees to follow the Thomases' example and take income out of an IRA whenever there will be little or no tax consequences. Healthy retirees may even want to forgo claiming early, reduced Social Security benefits as a way of minimizing taxes now and boosting their retirement benefits later, he says. For example, a retired couple with no income other than IRA distributions could withdraw $17,500 tax-free this year, thanks to a $10,700 standard deduction and personal exemptions of $3,400 each. (If they are 65 or older, they qualify for an extra standard deduction of $1,000 each.) The next $15,650 of income would be taxed at 10%, the lowest federal tax bracket. Advertisement And your heirs will thank you for tapping your IRAs now. Heirs must pay income taxes on inherited IRAs at their top tax rate (the exception is inherited Roth IRAs, which are tax-free). With taxable accounts, beneficiaries inherit the stepped-up basis of the assets' value on the date of death of the original owner. That means that when they sell the assets, they'll pay capital-gains taxes only on the appreciated value since they inherited them.