Why a retirement income waterfall matters

Retirees face three simultaneous challenges: replacing paycheck income, managing taxes, and protecting portfolio longevity against market volatility and inflation. A Retirement Income Waterfall gives structure to those decisions by ranking income sources into tiers and defining when and how to withdraw from each. In my practice as a financial planner, a clear waterfall reduces costly mistakes—like taking large IRA withdrawals in high-tax years or selling stocks in a down market—and makes cash flow predictable for budgeting and Medicare/Medicaid planning.

How a practical waterfall is commonly organized

Below is a practical, tax-aware waterfall many advisors use. This is a framework, not a one-size-fits-all rule; you’ll adjust order based on personal tax brackets, health, legacy goals, and pension/annuity guarantees.

  • Tier 1 — Guaranteed income (essentials): Social Security and defined-benefit pensions that cover basic living costs. These are the most reliable sources and should be used first to secure essential expenses. (See coordinating Social Security strategies for details.) Coordinating Social Security with Retirement Withdrawals is a useful internal reference for sequencing claim ages and pension offsets.

  • Tier 2 — Short-term liquidity and protection: Cash, high-yield savings, short-term CDs, and short-duration bonds for emergencies and 1–3 years of spending. This prevents forced sales of long-term investments during market downturns.

  • Tier 3 — Taxable investment accounts: Brokerage accounts and other taxable investments. Because withdrawals typically have favorable tax treatment for long-term gains and allow capital-loss harvesting flexibility, these are often tapped before tax-deferred accounts.

  • Tier 4 — Tax-deferred retirement accounts: Traditional IRAs, 401(k)s, and deferred annuities. Withdrawals count as ordinary income and can push you into higher tax brackets or affect Medicare premiums and Social Security taxation, so use them strategically.

  • Tier 5 — Tax-free accounts and strategic Roth use: Roth IRAs and Roth 401(k)s. These grow tax-free and are often held to smooth taxable income in later years, pay for large one-off expenses, or leave a tax-free legacy.

Note: This sequence is a widely used starting point, but many retirees reverse the middle steps depending on the size of Social Security/pension benefits, expected future tax rates, or the need to satisfy Required Minimum Distributions (RMDs).

Important tax rules and timing to consider (2025)

  • Required Minimum Distributions: SECURE 2.0 changed RMD rules; as of 2025, the RMD age is 73 for most account owners (see IRS guidance on RMDs). RMDs force withdrawals from tax-deferred accounts and can affect the waterfall plan, so build expected RMDs into projections (IRS: https://www.irs.gov/retirement-plans/required-minimum-distributions-rmds).

  • Tax treatment by account type: Withdrawals from traditional IRAs and 401(k)s are taxed as ordinary income; qualified Roth distributions are tax-free; taxable accounts receive capital-gains treatment for gains and step-up basis rules at death may affect legacy planning (IRS: https://www.irs.gov/).

  • Social Security claiming: Claiming early reduces monthly benefits; delaying increases them up to age 70. Claim timing affects how much you need from other tiers early in retirement (Social Security Administration: https://www.ssa.gov/).

  • Medicare & means-tested programs: Income affects Medicare Part B/D premiums and eligibility for assistance programs; withdrawals that spike AGI can raise premiums or create surcharges.

How to build a waterfall—step-by-step

  1. Calculate a realistic baseline budget for essential vs. discretionary spending. Separate non-negotiable essential expenses (housing, food, health insurance) from discretionary items (travel, gifts).
  2. Inventory all income sources and accounts: Social Security estimates, pension annuity schedules, balances in taxable accounts, IRAs/401(k)s, Roths, and cash reserves.
  3. Project guaranteed income first: Cover essential expenses with Social Security and pensions where possible. If guaranteed sources fall short, determine how much must come from liquid, low-risk assets.
  4. Design a cash buffer: Hold 1–3 years of essential spending in Tier 2 (cash/bonds) to avoid selling equities during down markets.
  5. Sequence taxable, tax-deferred, and Roth withdrawals based on tax projections: use taxable accounts for supplemental spending early, defer tax-deferred withdrawals while in a low bracket, and use Roths to manage later-year taxes or large expenses.
  6. Model RMDs: Add forced RMD outflows at the correct age and test how they change taxable income and Medicare costs.
  7. Stress-test the plan: Run scenarios for market downturns, longevity, inflation, and changes in Social Security or tax law.
  8. Review annually or after major life changes (health, relocation, death of a spouse).

Practical examples (simplified)

Example A: Married couple, both 66, Social Security covers 60% of essentials. They keep 24 months of living expenses in cash and draw the remainder from taxable brokerage accounts while letting IRAs grow until RMDs start at age 73. They convert modest IRAs to Roth in years with low income to reduce future RMDs.

Example B: Single retiree with a pension covering essentials chooses to delay Social Security to 70 to maximize guaranteed lifetime income. They live off cash and taxable investments for 4 years, then claim Social Security and begin drawing tax-deferred accounts only as needed, leaving Roth assets intact as a tax-free backup.

Tax-smart techniques often used

  • Roth conversions in low-income years to reduce future RMDs and taxable exposure.
  • Harvesting capital losses to offset gains in taxable accounts.
  • Layering annuities or single-premium immediate annuities (SPIAs) to convert a portion of investments into guaranteed Tier 1 income if longevity risk is a major concern.
  • Timing large withdrawals to avoid spiking Medicare IRMAA surcharges or increasing Social Security taxation.

Common mistakes and how to avoid them

  • Treating the waterfall as fixed: Your plan must change with tax law, markets, and personal needs.
  • Ignoring RMDs: Underestimating RMD timing can force large taxable withdrawals later.
  • Overreliance on home equity without a plan for liquidity or reverse-mortgage trade-offs.
  • Using Roths too early: Roth accounts can be powerful tax shields in later years; consider long-term value before spending them first.

Who benefits most from a waterfall

  • People with multiple account types (taxable, tax-deferred, Roth).
  • Retirees with a mix of guaranteed benefits (Social Security/pension) and investment assets.
  • Couples with unequal Social Security or pension entitlements who need a coordinated claiming/draw strategy (see our guides on bridging income before Social Security). For ideas on bridging income sources before you claim Social Security, see Bridging the Gap: Income Solutions Before Social Security Eligibility: https://finhelp.io/glossary/bridging-the-gap-income-solutions-before-social-security-eligibility/.

Integrating the waterfall with other planning areas

  • Social Security timing: Coordinate claiming with withdrawal sequencing and spousal strategies; delaying benefits can change which tiers you rely on and when. Our glossary entry on coordinating Social Security provides tactical options: https://finhelp.io/glossary/coordinating-social-security-with-retirement-withdrawals/.

  • Estate and legacy: The waterfall affects what you leave behind. Roth assets can deliver tax-free inheritances; be mindful of step-up in basis rules for taxable assets.

  • Health and long-term care: Consider how long-term care needs could rapidly change your withdrawal priorities and the value of converting liquid assets into guaranteed income.

Monitoring and review schedule

  • Annual review: Update income needs, account balances, and tax projections.
  • Event-driven review: After a major market drop, change in health, or legislative tax change.
  • Rebalance tax planning at least every 3–5 years to consider Roth conversions, planned charitable giving, or charitable remainder trusts.

Quick checklist before you implement

  • Estimate essential expenses, guaranteed income, and annual shortfall.
  • Set a target cash buffer for 1–3 years of essentials.
  • Model RMDs and Medicare impacts.
  • Decide a withdrawal order and document the triggers for changing tiers (e.g., market drop threshold).
  • Schedule an annual review with a CFP or tax advisor.

Professional disclaimer

This article is educational and not individualized tax, legal, or investment advice. Rules change—check current IRS guidance on RMDs and tax treatment (https://www.irs.gov/) and Social Security rules at the Social Security Administration (https://www.ssa.gov/). For a personalized retirement income plan, consult a certified financial planner or tax professional.

Sources and further reading

If you’d like, I can create a sample modeled waterfall using your account balances, estimated Social Security, pension amounts, and spending needs as a next step.