No matter how much you’ve saved, no matter how well your investments have done, it can be surprisingly scary to realize you will need to start living off your savings in retirement. Of course, your Social Security benefits will play a major role in covering your monthly expenses, and there are plenty of ways to generate income in retirement. But still — realizing that your principal must now be earmarked for the present as much as the future can be a sobering thought.
Every retiree should have a strategy for when they withdraw money from their accounts, which accounts they will draw from first, and how much they should withdraw every month, quarter, and year. There are many potential strategies to choose from, and a near-infinite number of ways to customize each strategy for you. Here are a few of the most common:
The Buckets Strategy. With this approach, you divide your savings into three buckets: Short-term, intermediate-term, and long-term.
The short-term bucket is the money you’ll need for the next 1-3 years. These funds would usually be invested in fairly liquid assets that don’t usually experience a lot of volatility. (Think cash, CDs, and short-term bonds.) Your intermediate bucket is for goals and needs approximately 3-5 years out. (Some people prefer reserving this bucket for as many as 10 years out.) Finally, your long-term bucket is, essentially, for the rest of your life. This should contain money that you want to see grow throughout retirement – and because you won’t need the funds anytime soon, you’re comfortable taking on a bit more risk.
The 4% Strategy. With this approach, you take 4% out of your portfolio in your first year of retirement. Then, every year afterward, you increase the amount you withdraw to be consistent with inflation. This helps ensure you continue drawing enough to maintain your lifestyle as prices go up. (Except in very rare circumstances, prices will always go up over time, even if the inflation rate isn’t particularly high.)
Now, your needed withdrawal rate may not be 4% in that first year. It could be 3%, or 5%, or whatever. The point is that you establish a “just enough” baseline early on that you gradually add to year over year to keep up with inflation.
Every strategy comes with both benefits and downsides, and this one is no exception. The downside is that the 4%-plus-inflation strategy can sometimes be a little too rigid depending on what’s going on in the markets or your life. For example, in a bear market, you may want to dial back on your spending so you don’t drain your investments too quickly. You may have a big travel or home maintenance year, in which case you might exceed the 4%.
However, if you expect both your spending and your expenses to remain fairly consistent each year, then some variation of the 4% strategy may work well for you. As always, it’s important that whatever strategy you choose be consistent with your overall financial plan. There is no such thing as a strategy that suits everyone. It will always require at least some customization!
The Proportional Withdrawal Strategy. Many investors have more than one investment account. For instance, a taxable brokerage account, a tax-deferred account like a 401(k) or traditional IRA, and a tax-advantaged account like a Roth IRA. Some retirees may withdraw from their taxable accounts first, then their tax-deferred accounts, and finally their Roth accounts. (While withdrawals made from a traditional 401(k) or IRA are taxed as ordinary income, qualified withdrawals from a Roth account are tax-free.) The idea here is to let the assets in your tax-deferred and tax-advantaged accounts grow for as long as possible.
The problem is that it can sometimes lead to a heftier tax bill. In fact, it’s common for a retiree to avoid touching their traditional IRA until they must begin making withdrawals at age 73…only to find that they have now pushed themselves into a higher tax bracket.
For this reason, a proportional withdrawal strategy is worth considering. With this approach, you first determine how much in total you need to withdraw each year. Then, you withdraw a proportionate amount from each account based on their respective percentage of your overall savings. For example, imagine that the value of your taxable accounts represents 30% of your overall savings, your tax-deferred account is 50%, and your Roth equals 20%. If, say, you needed to make $35,000 in total withdrawals each year, you would withdraw roughly $10,500 from your taxable account, $17,500 from your tax-deferred account, and $7,000 from your Roth. This spreads out the tax impact of your withdrawals and potentially leads to a lower overall tax bill each year.
Finally, we have the Guardrails Strategy. This is based on the concept of changing your withdrawal rate based on market performance. If the markets are in a long-term decline, you decrease your withdrawal rate. During a long-term bull market, your rate would increase.
Under this strategy, retirees set specific “guardrails” for their target withdrawal rate — a high guardrail and a low guardrail. If your actual withdrawal rate rises above your high guardrail, you reduce the amount you withdraw. If it falls below your low guardrail, you increase that amount. This approach is helpful if the value of your portfolio fluctuates dramatically due to how the markets are performing. It’s a dynamic way to withdraw money in retirement that adapts to market conditions rather than ignoring them.
All these methods have their pros and cons, and some retirees may even combine them together. The ultimate takeaway is that it’s critical to have a concrete strategy in place to govern your spending in retirement. It’s the best way to achieve the lifestyle you want — and the goals you care about — while simultaneously protecting yourself from overspending.
This material was provided for Joe Garrett’s use.
