By Anh Thu Tran, MBA
Turning savings into income
The decline in company pensions has resulted in more and more Americans becoming personally responsible for funding their own retirement. Countless articles have been written to help workers save adequately for this impending phase of life. Unfortunately, retiring with a sizeable nest egg is only half the battle. Withdrawing judiciously from your savings is the other (less discussed) half.
There are numerous variables that impact retirement success ̶ savings, spending, portfolio returns, health. While you can’t control all these elements, it’s important to plan for what you can control. One such lever is your retirement income withdrawal strategy. If you’ve been fortunate enough to have accumulated a decent nest egg, determining where and how to withdraw your income each year could help stretch your savings further and increase the probability of a successful retirement. To develop a viable income withdrawal strategy requires you to answer some key questions.
How much do you need to withdraw from retirement savings accounts?
To determine how much retirement income you will need, first, you must figure out your expected expenses for (ongoing) essential and non-essential needs. Rather than look at last year’s total expense, consider averaging your annual expenses over the past three years. This will give you more of a trendline, which is potentially a better predictor of your annual spending during the early retirement years. Remember, however, that some of your pre-retirement expenses will not carry forward, such as deferments into retirement savings. Also, you’ll likely see reduction in job-related costs like transportation, clothes, eating lunch out, etc.
Once you have a better sense of your annual spending, add up all your predictable annual income ̶ Social Security, pension (if you have one), rental income, dividends and interest. With this information, you can determine the gap that needs to be filled by withdrawals from your retirement savings accounts:
Annual Spending – Social Security – Pension – Expected Dividends and Interest – Rental Income – Other Income = Needed withdrawal from retirement savings accounts (401k, IRA, brokerage accounts)
(NOTE: When doing any form of forward-looking financial planning, it’s important to factor inflation into your future withdrawal needs. Historical inflation over long periods of time has averaged about 3% per year, but has been much lower than that for the past decade.)
How much can you safely withdraw from your retirement savings accounts?
Here’s the balancing act: withdraw enough income so that you’re able to live comfortably, but not withdraw so quickly that you drain your accounts well before you die – the biggest fear for many retirees. A common rule-of-thumb (which doesn’t suggest that it applies to you, but is simply a guideline) is the 4% withdrawal rule. It suggests that your invested savings will usually be sustainable for a 30-year retirement if you withdraw no more than 4% of the starting balance each year (adjusting for inflation annually). (NOTE: This 4% is before tax. Depending on the tax character of your investment accounts, the 4% may not go as far for you as someone else.) Hopefully, the after-tax income generated by the 4% rule is more than your annual need. Of course, investment returns play an important role in sustainable lifetime income. The 4% rule assumes your portfolio is invested in a diversified, balanced portfolio of stocks and bonds. It is also important to understand that this consistent income rule may not provide enough income to cover non-recurring expenses; one-time or occasional big-ticket expenses may need to be accounted for beyond the 4% rule.
Does it matter from which retirement savings accounts you withdraw your retirement income first?
Yes! If you’re like many retirees, your retirement savings fall into these main categories:
- Taxable: brokerage accounts, savings account, inheritance
- Tax-deferred: 401k, traditional IRA, 403b, 457 accounts
- Tax-free: Roth IRA, Roth 401k or municipal bond accounts
Given the different tax treatments and other regulations pertaining to these accounts, it’s important to determine which would be most advantageous to withdraw income from first. Again, the general rule-of-thumb is that if you foresee your marginal income tax increasing in the future, it’s best to withdraw from your taxable account first, followed by your tax-deferred account and then your tax-free account. The rationale is that if you withdraw from your taxable account and then your tax deferred account in the early retirement years, you’ll be able to take advantage of the lower marginal tax rate before it creeps upward due to forces, such as required minimum distributions (RMD) from IRA/401k beginning at age 70 1/2. Additionally, by withdrawing from these accounts first, you give your tax-free account more time to grow and compound.
However, if you foresee your marginal income tax decreasing in the future, then it’s probably best to withdraw from your tax-free account(s) first. As your marginal income tax decreases, you can shift withdrawals to taxable accounts. In brokerage accounts, you benefit from preferential treatment of qualified dividends and capital gains being taxed at a lower rate (for most people) than the ordinary income rate that applies to IRAs and 401ks. When you reach age 70½, you will be forced to begin taking RMDs from tax-deferred accounts. Once you begin withdrawing from these accounts, hopefully, you’ll be doing so at a lower marginal tax rate.
By developing a viable retirement income withdrawal strategy, you are anticipating (as best as possible) what your marginal tax rate will be in the future and taking advantage of the different tax characterization of your retirement assets to lower your taxes and, thereby, extending the life of your savings.
As with saving for retirement, when it comes to withdrawing retirement income, everyone’s financial situation is unique. However, by illustrating these scenarios, we hope to show how forethought and planning can improve your probability of success.
 NOTE: This assumes that you have chosen to delay Social Security and are not yet forced to take required minimum distribution (RMD) from tax-deferred accounts.
- Retirement Spending: More difficult than retirement saving
- Retirement spending varies by age band
- How are you spending down your retirement nest egg?
- Retirement decisions timeline
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