Lack of retirement readiness among American workers receives a lot of attention in the press, and rightly so. Depending on which study you read, this is an issue of varying severity. Accumulating a retirement nest egg is tough in today’s world, where defined-contribution plans are the primary retirement savings vehicle.
Once you reach retirement (and even if you have saved enough), it’s not smooth sailing. As important as saving enough for retirement is managing the drawing down of your retirement savings.
You may need to make your money last nearly as long as you worked. How do you make your money last for 30 years or more?
- Many retirement planning programs and online calculators look at withdrawals as somewhat fixed. In reality, withdrawals may vary.
- Appreciated taxable investments are taxed at preferential capital gains rates as long as you hold them for at least a year and a day.
- Conventional wisdom might say to delay paying taxes as long as possible and to always take funds from the source with the least tax impact. This makes sense to a point.
Retirement Income Sources
First, look at all the resources you have to fund retirement. These might include:
- Social Security
- 401(k) plan or similar defined contribution accounts
- Individual retirement accounts (IRAs)
- Taxable investments
- Employment or self-employment income
- An annuity
- A health savings account (HSA)
There could certainly be other resources, but these are among the most common. You need to determine from these and others what income and cash flow you'll likely be able to generate during retirement.
Hopefully, you've done a retirement budget and have an idea of what your income needs will be. Living expenses, travel, medical costs, and the like should be included. So should lifestyle changes, such as relocating or downsizing a residence. Social Security and possibly pension decisions should be made, or at least the ramifications of making one choice over the other should be considered here.
In the case of Social Security, when will you take your benefit? Can you wait until your full retirement age or age 70? If you're married, does one of the claiming strategies available to married couples fit your situation?
If you have a pension, taking a lump-sum versus a lifetime stream of payments should be analyzed, if both options are available.
How Much to Withdraw?
Once you've gone through these steps, start planning a withdrawal strategy. (This assumes that your financial resources are sufficient to support your lifestyle or, if not, that you adjusted your planned spending.)
Many retirement planning programs and online calculators look at withdrawals as somewhat fixed, either in nominal or inflation-adjusted terms. In reality, withdrawals can vary. For example, earlier in retirement, you may be working and drawing a salary, even if it's just part-time. This would reduce the amount you need from your retirement accounts and allow you to delay filing for Social Security.
Then there are required minimum distributions (RMDs) for 401(k) and traditional IRA accounts and some other retirement plans. Once you reach age 72, the government will dictate a withdrawal strategy for those payments. (The RMD age was previously 70½, but was raised to 72 following the recent passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act).
You may have several retirement accounts from which to draw funds. Some may be tax-deferred, such as a traditional IRA or a 401(k) account; withdrawals from those accounts are taxed at your highest marginal rate. A Roth account (assuming you follow the applicable rules) provides tax-free withdrawals, as does an HSA account when you use it to cover qualified medical expenses.
Appreciated taxable investments are taxed at preferential capital gains rates as long as they are held for at least a year and a day.
Conventional wisdom might say to delay paying taxes as long as possible and to always take funds from the source with the least tax impact. This makes sense, to a point. The time value of money principle says that delaying taxes is a good idea.
But it might make sense to pay some additional taxes now to reduce taxes in your retirement. For example, if you're in a relatively low tax bracket in retirement but are not yet age 72, it might make sense to convert some of your traditional IRA money to a Roth IRA. This will cause an added immediate tax liability but can remove the need to take RMDs from that account during your lifetime. If you don’t need the RMD money to support your lifestyle, this allows more money to remain invested. If you do, the withdrawals will no longer increase your taxable income.
Also, if you're still working at retirement age and in a higher bracket than you will be later, try to limit yourself to taking withdrawals from your tax-free savings, such as a Roth IRA. The tax bite on your taxable funds will be lower when you earn less and your bracket drops. For example, if you move from the 32% bracket to the 24% tax bracket, a $10,000 withdrawal from a traditional IRA will rise from netting you $6,800 to netting you $7,600. That's $800 more.
If it's not an RMD, try to keep out of your taxable retirement savings when you're still in a higher bracket.
A Bucket Approach
A bucket approach to retirement entails setting up three buckets, or portions, of your retirement nest egg. Bucket number one would contain enough cash or very low-risk, short-term fixed-income investments to fund several years of your anticipated needs in retirement. This protects against having to dip into stock investments to fund your retirement during a declining market in the future.
The next bucket would contain moderately risky investments that offer more growth or income. These might include high-quality fixed-income investments, dividend-paying stocks, or moderate-risk balanced mutual funds.
Be sure to look at all the resources you have at your disposal for funding your retirement.
The last bucket contains growth vehicles such as stock mutual funds and exchange-traded funds (ETFs). This portion of the portfolio is designed for the growth that most retirees will need to make their money last in their retirement years.
In choosing where to place these investments, consider such factors as taxable and tax-deferred accounts. This last bucket will be more at risk during a downturn, so fund it with money you could manage without if the market goes against you.
The Bottom Line
Don't take lightly the way you withdraw from retirement savings. There can be significant tax advantages to taking withdrawals from one account over another, and the order of withdrawal can vary based on your circumstances at various stages of retirement.