When you are thinking about withdrawing money from your retirement accounts, it’s important to come up with a strategy that ensures that your savings are going to last for a lifetime, are used efficiently, and are not diminished by heavy taxation.
Your starting point for retirement withdrawals will be any funding gap between your fixed and semi-fixed sources of income and the amount needed to fund your retirement spending.
A key part of developing a retirement withdrawal strategy is to inventory all of your sources of retirement income –especially fixed income sources. Some typical sources of fixed retirement income include:
- Social Security benefits
- A pension
- Annuities (annuities can fall in the fixed and variable camp, depending upon whether you annuitize the contract)
Income from a retirement job or a passive income source – for example, a rental property – should also be considered. Your retirement withdrawal needs might not be as great for the time periods when you have these types of additional income sources.
It is critical to be able to predict how much you will be spending in retirement. It may also be useful to distinguish between your spending needs and wants. It is important to know how much you need to withdraw to make ends meet (versus how much you would like to be able to withdraw to support your desired lifestyle).
A good retirement calculator can help you figure out your overall retirement budget. The NewRetirement retirement planner enables you to set different spending and income levels for any time period throughout retirement. When your expected income won’t cover expenses, the calculator simulates the necessary withdrawals from savings, as well as estimating the tax expenses when drawing from qualified retirement accounts.
Usable assets are a combination of retirement and non-retirement investment accounts, as well as other sources. These other sources will vary from person-to-person.
- Proceeds from a corporate buyout if you took advantage of any early retirement offer
- 401(k) and similar retirement accounts
- IRA accounts
- Taxable investments/accounts
- Health savings accounts (HSAs)
You might even want to include your home equity as an asset. You can downsize or get a reverse mortgage to support efficient spending.
A well-known rule of thumb for determining how much you can safely withdraw from your retirement accounts is referred to as “the 4% rule.” The 4% rule was developed by financial advisor Bill Bengen in the mid-1990s.
This rule was not meant to be a hard-and-fast rule governing how much can be safely withdrawn, but it can serve as a starting point.
For example, a $1 million nest egg can safely support a $40,000 gross annual withdrawal over a 30-year period (assuming a reasonably well-balanced portfolio according to this methodology).
However, to do this calculation and then rely on it in a dogmatic way is a mistake with potentially dire consequences for investors. The 4% rule should be thought of as a great estimating tool: a “back of the napkin” approach. It’s an excellent way for someone approaching retirement to get a feel for what type of annual distributions their various retirement accounts can support.
The 4% rule (or any other rule of thumb) is not a substitute for doing an in-depth analysis based on where you stand each year, recent gains and losses in your accounts, and your changing circumstances in retirement.
While you likely don’t want to invest as aggressively as a millennial, retirement is not the time to take your money and put it under the mattress either. You still need to allocate your investments in a fashion that allows for growth ahead of inflation (with protection on the downside, as well). This allocation will vary from person to person based on each individual’s unique circumstances.
Many experts recommend a bucket approach – tailoring different risk levels for your investments for different kinds of spending. Most experts will say that there are several different approaches to investment strategies for retirement.
Assessing which account to make a withdrawal from is an ongoing process. The accounts and the order of tapping them will likely change a bit over time. You will want to think about: Is the account up or down for the year or overall? What is your tax situation for the year?
A key piece of your retirement withdrawals strategy will involve taxes. It is important to understand how taxes work for various accounts and investments, as well as for your overall tax situation. In some cases your options might be limited, but a tax-smart retirement withdrawals strategy can result in significant savings, and more importantly, can possibly help stretch your nest egg a bit longer.
Withdrawals from traditional 401(k) and traditional IRA accounts are fully taxable as ordinary income. The exception is any portion that was contributed on an after-tax basis, which is not taxed. This portion will be excluded from distributions on a prorated basis. In most cases, any distribution prior to age 59 ½ will incur a 10% penalty in addition to the taxes due.
Withdrawals from a Roth IRA are tax-free as long as you are at least 59 ½ and have met other requirements, such as the five-year rule. Withdrawals from a Roth 401(k) work in a similar fashion, though the rules are a bit different.
For non-qualified annuities (those not held inside of a retirement plan), any gains in the account are taxed as ordinary income. The premiums – the amount you put into the contract – are not taxed. If you annuitize the contract, a portion of each monthly payment will be considered a gain and, thus, taxed. In addition, a portion will be considered a return of the premium and, thus, not-taxed. If you take partial, periodic distributions from the account, the distributions will be treated as gains first (until all of the “gain layer” is depleted and taxed accordingly).
In the case of an annuity held in an IRA (or a similar type of account), the distributions will all be subject to tax just like any other traditional IRA distribution.
For investments held in a taxable account, interest and dividends received are taxable. Realized capital gains are also taxable. Short-term gains (for investments held less than a year) are taxed at ordinary income tax rates. Long-term capital gains are taxed at lower capital gains rates.
HSAs can be tapped into tax-free to cover qualified medical expenses. In an era of rising retiree medical costs, this could be a nice feature.
Taxes are an important factor as they impact the amount of spendable income you actually have. For example, $1 million in a traditional IRA does not mean that you have $1 million of spendable income because this amount will be reduced by the amount of taxes paid.
Over time it’s more likely that you will need to review, revise, and adjust your retirement withdrawals strategy in terms of the amount you take and the accounts from which withdrawals are taken.
Things change in the markets, the economy, and your own situation. Investment results will vary, in addition to your spending needs. Your spending needs are based on what is happening in your life. There could be health situations or other unforeseen events.
The bottom line here is that you need to revisit your withdrawal strategy each year, look at your needs, and look at your resources. A fixed withdrawal percentage of your nest egg over a 30 year (or greater) retirement time frame may not be realistic.
An example of being flexible might involve withdrawing extra money in the years prior to reaching age 70½ and required minimum distributions (RMDs). Depending upon your income and tax bracket, you could potentially reduce what you owe the IRS by proactively reducing the amount subject to RMDs down the road.
It may also make sense to convert some traditional IRA money to a Roth and pay the tax to avoid RMDs, as well.
It can be tempting to deplete your taxable accounts first to avoid taxes or pay them at the lower capital gains rates. This might not always be the best option as this eliminates any type of tax flexibility down the road.
Another decision that could change your withdrawal strategy revolves around when you claim Social Security.
There is a big advantage to using a detailed retirement calculator that saves your information so you can adjust your inputs over time. You can easily see the impact of retirement withdrawals, rates of return, different levels of spending, and different levels of income.
Saving, investing, and planning for a comfortable retirement is a difficult task. However, the work doesn’t stop once you reach retirement. Managing withdrawals from your retirement accounts is an ongoing process. You need to be diligent and flexible in order to succeed.
Use the NewRetirement retirement planner to instantly see how much you need to withdraw each year and find out if you will run out of money.
