A lack of financial readiness for retirement 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 challenging 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 necessarily smooth sailing either. Managing the drawdown of your retirement savings is just as important as saving enough for retirement.
With retirement years increasingly extending longer for some, 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.
- The conventional wisdom of delaying paying taxes as long as possible and withdrawing funds from low-tax impact sources may not always apply.
Retirement Income Sources
First, look at all the resources you have to fund retirement. There could be others but these are the most common:
- 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)
You need to determine from these and any other sources of money that you have, the income and cash flow you'll likely be able to generate during retirement.
Hopefully, you've created a retirement budget and have an idea of what your income needs will be. Living expenses, travel expenses, medical costs, and the like should be included. So should lifestyle costs related to relocating or downsizing a residence.
The ramifications of social security payments and possibly pension decisions should be considered.
In the case of Social Security, when will you take your benefit? Can you wait until your full retirement age or beyond to 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 Should You Withdraw?
Once you've gone through the above 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 fixed, either in nominal or inflation-adjusted terms. Inflation is the rate at which prices increase within an economy.
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 could reduce the amount you need from your retirement accounts and allow you to delay filing for Social Security.
Required Minimum Distributions
Then there are required minimum distributions (RMDs) for 401(k) and traditional IRA accounts and some other retirement plans. Once you reach age 73 (as of 2023), you must begin withdrawing a certain amount (determined by the IRS) from these accounts.
The RMD age was previously 72 but was raised to 73 following the passage of the SECURE 2.0 Act of 2022.
The Effect of Taxes
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, including the time value of money principle, might support delaying the payment of taxes as long as possible and to always take funds from the source with the least tax impact. This makes sense, to a point.
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 73, it might make sense to convert some of your traditional IRA money to a Roth IRA.
This will cause an immediate tax liability but removes the need to take RMDs from that account during your lifetime. If you don’t need the money to support your lifestyle, you can leave it invested. If you do need to take some money out, the withdrawals will no longer increase your taxable income because withdrawals from a Roth IRA are tax free.
Also, if you're still working at retirement age and are 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 may be lower when you earn less, and if your tax bracket drops. For example, if you drop to the 24% tax bracket from the 32% tax bracket, a $10,000 withdrawal from a traditional IRA will net you $7,600 instead of $6,800. That's $800 more.
If you don't have to take RMDs, try to avoid your taxable retirement plan savings when you're still in a high tax bracket.
Be sure to consider carefully all of the sources of income that you have for funding your retirement so you can make the most tax-savvy choices.
A Bucket Approach
A bucket approach to retirement entails setting up three buckets, or portions, of your retirement nest egg for withdrawals. 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.
The last bucket would contain 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 so that their money lasts throughout their retirement years.
In choosing how to separate these investments, consider such factors as taxable and tax-deferred accounts. The third bucket will be more at risk during a downturn, so fund it with money you could manage without if the market goes against you.
Is There a Strategy for RMDs in Retirement?
Since you have to take them, RMDs can be a top priority of retirement savings withdrawals. Yes, you'll have to pay ordinary income taxes on the amounts. But then, if you don't need all the money, consider placing the available funds in a taxable account where they can start growing again. Subsequent taxes will be at the capital gains tax rate, which is typically lower than tax rates for ordinary income.
What's a Source of Tax-Free Cash in Retirement?
If you have bonds or CDs that are maturing, they can be a smart source of funds in retirement. That's because when they're held to maturity, normally the principal isn't subject to taxes.
What's the 4% Withdrawal Strategy?
Some professionals suggest a starting withdrawal amount of 4% of your savings in the first year. Then, in the second year and every year thereafter, you'll adjust that percentage to reflect inflation. For example, if inflation has been running at 2.5%, add that to your 4% withdrawal amount. The disadvantage of this approach is that if rates are rising, you'll withdraw increasingly higher amounts of money and may deplete your savings.
The Bottom Line
Take care to consider very carefully the way that you should withdraw money from your retirement savings. There can be significant tax advantages to taking withdrawals from one account over another. What's more, the order of the accounts from which you withdraw can vary based on your circumstances at different stages of retirement.