How much should you withdraw from your tax-deferred 401(k) or IRA, and in what form? Here's a brief summary of four retirement income withdrawal methods to help you optimize the decumulation of your retirement income portfolio prudently.
Goals, Obstacles, And Taxes
Your strategy must annually balance withdrawing enough to live comfortably against making your assets last a lifetime. Taxes are a material consideration, since traditional IRA, 401(k) and 403(b) accounts are taxed as ordinary income.
Withdrawals before age 59½ are subject to a 10% early withdrawal penalty. In addition, you must start withdrawing from federally qualified retirement accounts when you reach age 70½. However, under provisions proposed in the SECURE Act, which is expected to become law by the end of 2019, the required minimum withdrawal age will be pushed back to 72. An extra 18 months of tax-deferred growth at your age is a nice unexpected bonus.
To minimize taxes on withdrawals, consider paying tax on these assets now and placing them in Roth IRAs, where you pay taxes up front instead of when you're retired. The four methods are:
You divide your retirement assets into three separate accounts. The three buckets allow you to set aside a segment of your investments to grow, while having the assurance of a steady income stream.
Your first bucket is in cash, meaning short-term instruments. Replenishing the cash bucket with earnings generated by the other two buckets enables a quantitative discipline like dollar-cost-averaging.
It's currently not uncommon for these short-term accounts to pay 1.8% to 2.4% annually. A minimum deposit of $5,000 or so is commonly required. Expect to fractionally beat inflation annually, and do not expect capital appreciation. Read the prospectus, of course, or call us.
In all, you allocate three to five years' worth of living expenses, around 20% of your investments in cash, to the first bucket. The second bucket contains fixed-income assets, most often bonds or bond mutual funds and yield interest income.
The third bucket is for stocks. This remains the growth component of your portfolio, as stocks tend to grow the most over the long-term. They get socked the worst during recessions, too, which is why they aren't subject to the near-term withdrawal with the bucket strategy, which would sap your financial security over time.
The 4% annual withdrawal method aims to preserve your wealth yet throw off enough to live on. You simply withdraw 4% of your investments annually to start, and, thereafter, annually adjust it for inflation. The 4% method over 30-years is a prudent way to manage the risk of outliving your money. With this withdrawal scheme, and a $1 million retirement account, you would withdraw $40,000 the first year, $40,800 in year No. 2, and $41,616 in year three, assuming a 2% inflation rate.
The virtue of the 4% solution is simplicity. The downside is that, in the event of a bear market loss, you must be prepared to withdraw less and perhaps live more modestly. In The Great Recession of 2008, stocks dropped and lost nearly half their value, for example. If stocks made up 60% of your portfolio, even this prudent method put a big dent in your retirement income portfolio and took years to recover from.
Fixed Dollar Withdrawal
With this approach, you withdraw a fixed amount each year, perhaps a flat $40,000. After two or three years, you would reassess the annual amounts you are withdrawing to ensure you are comfortable with the way it is going. A fixed dollar method is a simple approach, and you can instruct your IRA custodian to withhold an amount to pay for taxes on the income withdrawn each year.
The trouble is, this strategy will not insulate you from inflation and fixed dollar withdrawals are not mindful of year-to-year depletion of your nest egg due to market downturns in stocks, bonds and other risk assets.
The inflation rate has been below 2% for years and is expected to remain low, but that could change and a decline in stock or bond prices in combination with your fixed withdrawals could precipitously shrink the size of your portfolio.
Another strategy that's easy to administer is to withdraw only the interest and dividends your portfolio accrues. This allows your principal to grow over time and better ensures a retirement income portfolio. The disadvantages are that you won't take out the same amount each year, and conservative income investors must accept the risk of owning stocks as well as bonds or be prepared for the risk that their fixed-income portfolio will result on less real retirement income.
These methods are tools for making a retirement income portfolio custom built to your personal specifications. No single method is best. While the 4% strategy is the method favored for long-term investors, the fixed dollar withdrawal may make sense depending on your health, Medicaid planning, and other personal details. Please call our office with any questions.
This article was written by a veteran financial journalist. While these are sources we believe to be reliable, the information is not intended to be used as financial or tax advice without consulting a professional about your personal situation. Tax laws are subject to change. Indices are unmanaged and not available for direct investment. Investments with higher return potential carry greater risk for loss. No one can predict the future of the stock market or any investment, and past performance is never a guarantee of your future results.