Most Americans spend decades of their lives working and planning to save for retirement. However, when they get close, there is very little discussion on how to plan for retirement income and distributions.
There are right ways and wrong ways to plan for retirement income, and the best way is to have a R.I.T.E.® plan (retirement income taxed efficiently). With proper financial and tax planning, you’ll be better positioned to achieve your retirement goals and to close any retirement income gap you may have to reach them.
Setting Your Retirement Withdrawal Rate
The amount you take out each month or year from your portfolio (whether it be an amount or percentage) is known as your withdrawal rate. Planning and knowing an appropriate starting withdrawal rate is a key point for analysis when creating your retirement plan. Your goal and decisions should consider the balance of taking too much and possibly running out of money vs. not taking enough and failing to enjoy your earlier active retirement years. Knowing and targeting your appropriate withdrawal rate is very important early on in retirement, as it will most likely have the largest impact on how long your savings last.
The most often quoted rule of thumb states that you can withdraw 4% annually from a balanced portfolio of stocks and bonds. Many studies show that this can provide inflation-adjusted income for up to 30 years without running out of money. In my readings, many contend that you should budget withdrawing somewhere between 3% and 5% depending on life expectancy, tax issues and market performance. However, these rules were based on historical data and are not guaranteed. There’s no perfect rule of thumb that works for everyone in every situation. (For related reading, see: Will a Systematic Withdrawal Plan Work for You?)
In order to determine your safe withdrawal rate, you need to formalize your overall financial planning goals that include your retirement, investment and estate plans. In creating your formal plan, you are able to identify:
- All your sources (sometimes called “buckets”) of retirement income: IRAs, 401(k)s, pensions, Social Security, deferred compensation, and other assets.
- Your cash needs or retirement budget to help you determine the current and future withdrawals that you will need to supplement your expected and guaranteed income sources (i.e. pensions or Social Security).
- Tax issues and opportunities that may need to be addressed, especially for those in higher tax brackets or if retiring younger where you would be subject to distribution penalties. (For related reading, see: Avoiding IRS Penalties on Your IRA Assets.)
- Tax-efficiency in your overall portfolio allocation and tax placement by reviewing all of your accounts and the underlying holdings to make sure that, where possible, tax inefficient investments are held inside pre-tax (retirement) accounts while more tax efficient investments are held in after-tax accounts.
- Your needed or required distributions (such as RMDs).
- Your family and/or charitable goals.
- How much risk you want and/or need to take in terms of your portfolio allocation and ongoing investment strategy. To do this effectively, you should stress-test your plan and know your hurdle rate (the minimum return you need to reach your retirement distribution goals). (For more from this author, see: Retirement Planning: What's Your Hurdle Rate?)
Proper planning will help you know what you can and should be able to distribute as a withdrawal rate from your retirement portfolio now and into the future.
Which Bucket Should You Drawdown First?
If you have been wise, you will have assets in multiple accounts that are taxable, tax-deferred, and tax-free. So how do you plan where to take money from first when you start retirement? The answer is...it depends.
If you are single and don’t have a goal of leaving a large estate to your beneficiaries or charities, many say you should start by withdrawing money from taxable accounts first, then tax-deferred accounts, and only then from your tax-free accounts. By waiting on taking money from your pre-tax and tax-free accounts, you’ll defer taxes as long as possible while keeping keep more of your retirement dollars working for you. (For related reading, see: Not All Retirement Accounts Should Be Tax-Deferred.)
If you are married or have family goals, it gets more complicated. You will need to coordinate your retirement and estate plans. For example, if you have rapidly appreciating assets and/or highly concentrated stock positions with a low tax basis, it may be beneficial to withdraw from tax-deferred accounts first (especially in low tax years) as these accounts will not receive a step-up in basis at your death. You also should consider the benefits of a rollover of your retirement plans.
Know How to Better Optimize Your Plan and Be Tax Smart
In addition, you can really turbo-charge your retirement plan by identifying appropriate strategies and by being tax smart (the “tax efficiently” part of the R.I.T.E.® plan). This can be done by planning for and knowing your:
- Options to maximize the value of your Social Security benefits – especially if you are married
- Pension plan distribution options and determining how to best choose options in light of your plan and goals
- 401(k) plan rollover options – especially if you have employer stock that could benefit from net unrealized appreciation (NUA) in a rollover/distribution and if you have after-tax dollars
- Expected tax brackets to better utilize retirement years where you would be in a lower tax bracket. When this is known, you can utilize various retirement rollover and Roth IRA conversion strategies that may be very beneficial while avoiding typical rollover mistakes.
You have spent decades saving for retirement. Given that investment of time and money, as you approach or enter retirement you should take the time to review your available alternatives and opportunities to meet your financial planning goals and objectives. This will help you make the best decisions for you and your family.
(For more from this author, see: Avoid Money Worries With Proper Planning—Part 1.)