As baby boomers make the transition from career to retirement, more and more people are grappling with the question you raise: How do you turn the money you've accumulated in 401(k)s, IRAs and other accounts into reliable income that, along with Social Security and any pensions, can support you the rest of your life?
In many ways this can be more challenging than saving for retirement. You don't have as much time to recover from market setbacks or planning errors, and the stakes are high: Run through your savings too early and your post-career years could be grim.
Still, if you start with a reasonable plan and understand that you'll likely have to tweak it as your personal circumstances and financial conditions change, you should be able to live off your nest egg without depleting it too soon.
Here are three tips that can help you create a strategy to do just that.
1. Take care in choosing a withdrawal rate. You'll often hear that if you want your retirement savings to last at least 30 years, you should follow the 4% rule -- that is, withdraw 4% of the value of your retirement savings initially and then increase that dollar amount annually by the inflation rate to maintain your purchasing power.
But while the chances of your nest egg lasting through a long retirement have historically been relatively high -- say, 80% or so -- if you stick to the 4% rule, there's no guarantee your money won't run out. Indeed, new Morningstar research suggests that with bond yields so low these days, investors may have to start with an initial withdrawal rate of about 3% if they want a high level of assurance that their savings won't run dry.
My suggestion: Go to a retirement income calculator and run several scenarios in which you withdraw different initial amounts (say, 3% to 5% of your nest egg) over different periods of time (maybe 25 to 30 years). By seeing how long your savings will last, you'll be better able to decide whether drawing more money from savings to live better today is worth the increased risk of falling short tomorrow.
2. Pay attention to "withdrawal sourcing." Withdrawal sourcing is a fancy term for deciding how to tap savings in different accounts -- tax-deferred 401(k)s and IRAs, tax-free Roth accounts and taxable accounts -- tax efficiently to maximize your spending cash in retirement.
Generally, you want to pull money from taxable accounts first, as at least some of the investment gains in those accounts may be taxed at the generally lower long-term capital gains rate.
You would then move on to tax-deferred accounts like traditional 401(k)s and IRAs and, finally, Roth accounts. Following this order will give the balances in your tax-advantaged accounts more time to compound without the drag of taxes, boosting your retirement income.
That said, you don't want to adhere to this system too rigidly.
In some years, you may be able to realize losses in taxable accounts that can offset taxes on draws from your 401(k) or IRA. Drain your taxable assets too soon and you'll lose that flexibility.
And once you reach age 70 ½, for example, federal rules require that you withdraw at least certain minimums from traditional IRAs and, unless you're still working, 401(k)s. Failure to do so carries a hefty penalty -- a 50% tax on the amount not withdrawn -- so you'll want to be sure to make at least the required withdrawal each year before deciding which accounts to tap next.
Besides, given politicians' propensity for tinkering with the tax code, keeping at least some money in different accounts that receive different tax treatment will give you more maneuvering room for minimizing taxes on future withdrawals.
3. Stay flexible. Whatever drawdown strategy you start with, be prepared to do some fine-tuning.
If the combination of withdrawals and sub par investment returns puts a sizable dent in your retirement account balances, then you may want to reduce the amount you withdraw from savings for a couple of years to avoid depleting your stash too soon.
If, on the other hand, a rising market causes the value of your nest egg to swell, then you might want to boost withdrawals so you don't end up with a big pile of savings in your dotage, along with regrets that you didn't spend more earlier in retirement when you might have enjoyed it more.
By going to an online retirement income calculator each year and plugging in your updated account balances and planned spending, you can see whether the probability of running through your savings is rising or falling, and modify your withdrawals accordingly.
Bottom line: Life and the financial markets are too unpredictable for you to know in advance exactly how to spend down your savings. But if you keep these three tips in mind, you can improve your odds of getting the income you need without going through your savings too soon.
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