Planning Your Retirement Income Distribution
Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)
When investors think about retirement plans, many focus on putting away cash and then investing it wisely to grow their nest egg. But there's a critical piece of retirement income planning that’s often overlooked: a strategy to withdraw those carefully tended savings.
While everyone's circumstances are unique, general principles apply to any retirement withdrawal strategy. It's just a matter of drawing up a budget that reflects all your income and spending expectations and devising a suitable distribution strategy.
Avoid tapping your more volatile investment assets to cover regular costs when you could be using income from more predictable sources.
Using predictable income or cash to cover expenses
You may no longer be getting a paycheck, but with proper planning, you can continue earning a steady income after you retire. Good practice is to pay for essential expenses with predictable income, and if possible, fund discretionary expenses with fluctuating income as appropriate for your needs.
For example, Social Security, pension payments, annuities,1 interest income, or even cash or short-term bonds kept in reserve are among the stable and predictable sources of income you can use to cover necessities like housing, car loans, food, and utilities. For most retirees, we suggest setting aside two to four years of essential expenses in cash or short-term bonds after accounting for other predictable income sources.
Then, fund discretionary expenses (i.e., "nice-to-haves") with growth assets or less certain or less guaranteed income sources from your portfolio. Stock dividends, distributions from mutual or exchange-traded funds, and proceeds from selling investments are often consistent, but not guaranteed, compared to the predictable income sources cited above. This can make them a better fit for nonessential items, like vacations, charitable donations, or gifts to a grandchild.
Another source of retirement "income" may be withdrawals from investments that have increased in value. Stocks or stock mutual funds, for example, provide potential for growth in your portfolio. However, they can be more volatile than predictable or guaranteed income sources.
Avoid tapping your more volatile investment assets to cover regular costs. Selling volatile assets when the market is down can be particularly costly. Instead, use a reserve of lower-volatility investments or cash balances to supplement income from more predictable sources of income.
Rebalancing your portfolio to generate cash flow
Selling investments to generate cash to support spending as part of annual or periodic portfolio rebalancing can provide another opportunity to generate cash flow. Generally speaking, this rebalancing process is especially important for retirees to manage the amount of more volatile investments, such as stocks, in their portfolio. For most retirees, decreasing your risk and exposure to stocks as you age may make sense, depending on your goals and distribution rate.
An out-of-balance portfolio can leave you with more risk or less potential for growth. In volatile markets, these risks can be magnified because retirees have less time than younger investors to potentially recover from losses or lackluster returns of a portfolio that's strayed from a chosen asset allocation.
Portfolios drift away from target allocations as certain asset classes rise or fall, leaving them over- or underweight areas of the market. To get your portfolio back on target during periods when stocks rise in value, you can sell from the stock portion of your portfolio to generate the cash you need to supplement other income sources. In fact, in down markets, the rebalancing process may lead you to tap investments that held their value or rose in value. (See "Selling investments in tax-deferred or tax-free accounts" below for more information.)
With an eye on the market, the natural process of rebalancing helps you know what to tap and when. However, remember that rebalancing won't protect you against losses or guarantee that you'll meet your goals.
Selling investments in tax-deferred or tax-free accounts
When selling assets, a general guideline is to tap investments in taxable accounts before taking money from tax-deferred or tax-free accounts, such as a traditional or Roth individual retirement account (IRA) or a 401(k).
That's assuming you have enough retirement savings in taxable brokerage accounts and haven't yet reached age 72 (70½ if you turned 70½ in 2019 or earlier), the age when the IRS requires you to begin taking required minimum distributions (RMDs) from traditional IRA or 401(k) accounts.
Tapping your IRA earlier means losing potential opportunities for tax-deferred compound growth. A possible exception is if your IRA balance is very large relative to other savings or if you need the money sooner. In that case, you might want to start taking distributions before you reach age 72.
Otherwise, when you start taking RMDs after age 72, you might be bumped up to a higher tax bracket. Withdrawals of pre-tax contributions and income from traditional IRAs and 401(k)s are treated as ordinary income—which is typically taxed at a higher rate than long-term capital gains in taxable accounts.2
Talk with your advisor or a tax professional to time your retirement income distributions wisely.
Funding your retirement with a strategic distribution plan
One mistake many retirees make is relying only on investment income to support retirement spending and not considering all return sources, including a rise in the value of their investments.
If you can live on investment income only, great. But don't do so at the expense of potential for growth in your portfolio or forget that you have four sources in your portfolio you could tap: interest, dividends, capital gains, and stable assets like cash.
Keep these points in mind as you structure your retirement portfolio and create your own distribution plan, and be sure to watch for changes in your spending or income to ensure that your expectations are on track. In a prolonged down market, for example, you may want to curb or postpone discretionary spending to avoid drawing down your portfolio too quickly.
Creating income during retirement might sound daunting, but it doesn't have to be. Three steps—starting with a plan, investing in a balanced portfolio, and then distributing income from a variety of sources—can help you simplify the process and lay the groundwork for the kind of retirement you've always wanted.
1 Annuity guarantees are subject to the financial strength and claims‐paying ability of the issuing insurance company. 2 Withdrawals are subject to ordinary income tax, and prior to age 59½, may be subject to a 10% federal tax penalty.
Investing involves risks, including loss of principal.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, please consult with a qualified tax advisor, CPA, financial planner, or investment manager.
Diversification, automatic investing, and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.0122-15MZ