Write Your Own Retirement Check

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

You've spent your whole life saving for retirement—now you're finished working, and it's time to start spending what you've saved. For many, making this transition can be confusing and perhaps even a bit traumatic. How much should you spend each year? Will you have enough? And which investments do you liquidate first?

Although this transition may seem daunting at first, this article will show you how to become your own boss. In effect, you'll be writing your own paychecks in retirement.

To be highly confident you won't run out of money prematurely, we suggest following to the 4% rule:

• Withdraw 4% of your portfolio in the first year of retirement.
• Then, grow the first-year dollar amount for inflation each year throughout your retirement.

There's nothing magical about the 4% rule. No matter how reasonable your assumptions, actual future returns and inflation rates will vary. That's why it's a good idea to stay flexible and not feel compelled to follow any general rule of thumb unconditionally (no matter how well-founded it might be).

For example, in years when the markets are down you may want to scale back on your withdrawals, while in up years you may feel freer to spend a little more. That said, if you plan on an initial withdrawal rate of about 4% of your portfolio's value, you should have a good ballpark idea of how much you can reasonably withdraw from your portfolio in the first year of retirement (or, conversely, how big your portfolio would need to be to support your long-term, inflation-adjusted spending needs).

After you've determined a reasonable portfolio withdrawal rate, follow these simple guidelines.

Always set aside a cash cushion

No matter what your starting portfolio asset allocation, the first thing to do is to set aside enough cash to cover your spending needs for the next 12 months—minus what you expect to receive from reliable non-portfolio sources of income, such as Social Security, pensions and so on. Place next year's spending cash in relatively safe, liquid investment vehicles such as:

• Money market mutual funds
• A bank money market deposit account
• Short-term certificates of deposit (CDs), perhaps laddered with three-, six- and nine-month maturities
• Checking accounts (preferably interest-bearing)

If you can, also put enough money to cover an additional two-to-four years' worth of spending needs in longer-term CDs, an ultra-short bond fund or high-quality short-term bonds as part of your strategic fixed income allocation. If your portfolio performs as expected, you can keep rolling over these shorter-term investments. But in the event of a lengthy bear market, you can cover living expenses by cashing them out instead of selling stocks from your retirement portfolio at the worst possible time.

Manage your retirement portfolio sensibly

With your short-term cushion safely in reserve and an additional cushion locked away in the fixed income portion of your portfolio, here are some sensible ways to manage your retirement portfolio:

• Diversify your portfolio across and within asset classes.
• Consider a "laddered" mix of high-quality bonds or bond funds with maturities of one to seven years.
• Keep tax-efficient investments in taxable accounts. This includes stocks held longer than one year, tax-managed funds, index funds, qualified-dividend-paying stocks and mutual funds, as well as municipal bonds (if they make sense for your tax bracket).
• Keep tax-inefficient investments in tax-deferred accounts. This includes stocks held one year or less, actively managed funds, taxable bonds and real estate investment trusts (REITs).

What if your annual spending needs exceed the aforementioned Social Security and pension income, plus potential interest income, dividends and mutual fund distributions? Then a good way to generate cash is through periodic asset allocation rebalancing.

But beware of pitfalls particular to the spending phase of retirement. Try to avoid automatic reinvestment of mutual fund distributions in taxable accounts. Instead, think about having the distributions automatically swept into a money market fund to help meet your spending needs. You won't have to sell as many shares that way, and because you won't have to track reinvested distributions, you'll have one less headache going forward.

Consider these key exceptions

Before making any attempts to liquidate securities according to our guidelines, there are several exceptions you should consider:

• Required minimum distributions. If you are age 70½ or older and are subject to required minimum distributions (RMDs), withdrawals from traditional IRAs will need to be considered first—at least up to the amount of the RMD.
• Tax bracket ramifications. If you're younger than age 70½, you may still wish to tap traditional IRAs, to the extent you're able, to better manage your tax bracket. For example, you may want to take out just enough to stay in the 15% bracket or close to it—especially if doing so helps reduce the potential tax hit on future RMDs. Or it might make sense to convert a traditional IRA to a Roth IRA for income tax and/or estate planning purposes. Finally, you may wish to postpone the sale of low-basis securities in taxable accounts for gift and estate or charitable purposes.
• Bonds maturing in the coming year. Consider bonds maturing within the next 12 months as part of current-year cash flow, before liquidating other assets at a taxable gain.
• Securities held for slightly less than a year. Assuming there's no undue risk in maintaining the position, try to postpone the sale of taxable-gain securities held 11 months or less until long-term status has been reached—that is, until you've held the position for at least one year and one day from the original date of purchase.
• Other special situations. You may also have special situations where tax-loss harvesting, matching of gains and losses and other tax issues override the general guidelines outlined below in Three Steps Toward a Steady Retirement Income Stream. Talk to your tax advisor to see if any of these circumstances apply.

Determine where the money will come from

Once you've decided on an appropriate portfolio asset allocation and have figured out how much you need from your portfolio for the year, you're left with one final question: Where should the money come from?

• Dividends and interest versus selling shares. Most likely, it will be both. For example, if you choose a moderately-conservative target asset allocation (40% stocks, 50% bonds and 10% cash), you might expect an average annual total return of around 5%. If you have a 30-year retirement time horizon, then the goal is to withdraw 4% of your portfolio in the first year of retirement and adjust that dollar amount for inflation during the rest of your retirement. Over time, your annual portfolio withdrawals will likely come from taking a total return approach—a combination of dividends, interest and share sales to realize a portion of the capital appreciation on your investment.
• Which investments should you sell? Perhaps the best approach is to take care of your cash flow needs at the same time you rebalance your portfolio back to your target asset allocation each year. As you reallocate your assets, you can take out the cash you need. For example, if your target allocation were 40% stocks and 50% bonds—but your portfolio had drifted to 45% stocks and 45% bonds—you could cash out what you needed from the stock portion and then reallocate what was left to bonds until you were back on target.
• Taxable versus tax-deferred accounts. It's usually better to sell long-term investments held in taxable accounts instead of taking money from tax-deferred accounts before you have to. Withdrawals from traditional IRAs and 401(k)s are taxed as ordinary income—typically at a higher rate than the preferential long-term capital gains rate. What's more, tapping your IRA means losing opportunities for tax-deferred compound growth.
  
  However, there are possible exceptions to this general rule: If your IRA balance is very large, you may want to draw from it before the age of 70½, when the RMDs kick in. Otherwise, the RMDs may bump you up to a higher tax bracket.
  
  For estate-planning purposes, your taxable estate includes your IRA balance—and on top of that, your heirs will owe income tax on any distributions they take from your IRA. Drawing down your IRA during your lifetime and leaving taxable accounts to heirs could be an effective strategy. If you have both a traditional IRA and a Roth IRA, consider drawing from the traditional IRA first. The Roth is still included in your taxable estate, but at least your beneficiaries will be able to take distributions tax-free.

Ready to begin writing those retirement checks? Check out this easy-to-use guide for what to sell when—and from which accounts.