When it’s time to make the shift from saving for retirement to living off your savings, what’s the best way to create a steady stream of income that lasts as long as you do?
“If you want your portfolio to go the distance, it helps to have a plan,” says Rob Williams, vice president of income planning at the Schwab Center for Financial Research. It’s not just a matter of selling a few assets and pocketing the proceeds, he says. You need to think about how your withdrawals will work with other sources of income—such as dividends, interest and Social Security—and consider how your asset allocation and tax situation will shift over time.
Here are three common challenges you might face once you start tapping your portfolio for income:
- Knowing which accounts to tap
- Navigating a bear market
- Making adjustments as needed
Challenge 1: Knowing which accounts to tap
One of the hardest parts of tapping your portfolio for retirement income is figuring out how to withdraw the funds in a tax-smart way. As you approach your first withdrawal, you may be asking yourself:
- Which assets should I tap first?
- How can I minimize my tax bill?
The questions go hand in hand because withdrawals from most accounts will trigger some sort of tax liability. Generally speaking, you want to spend down your assets in the following order, depending on your age:
- If you’re younger than 70½, advisors typically suggest that you should tap your taxable accounts before withdrawing money from tax-advantaged savings accounts—such as 401(k)s and IRAs—so that the money in those accounts can continue to grow as long as possible without generating a tax bill. Not only that, but long-term capital gains from taxable accounts are typically taxed at a lower rate than withdrawals from tax-deferred accounts, which are taxed as ordinary income. If you have a large balance in a traditional IRA, however, it might be advantageous to start taking distributions before you reach age 70½ in an effort to reduce the size of future RMDs and smooth out your tax bill. Otherwise, larger RMDs later may bump you into a higher tax bracket once they kick in (see “The RMD reality,” below).
- If you’re 70½ or older, you should tap your tax-deferred accounts first in order to satisfy your required minimum distributions (RMDs) for the year. (Failing to take your full RMD will result in a penalty equal to 50% of the difference between your full RMD amount and what you actually withdrew.) If you need additional income after withdrawing your full RMD amount for the year, you can tap your taxable accounts, selling off long-term gains first in order to minimize your tax hit, and take additional withdrawals from tax-deferred accounts to deliver the remaining income you need.
The RMD reality
Many retirees are surprised by the size of their RMDs, especially as they age. Here’s a look at RMDs for accounts of various sizes.
Source: . Assumes a birth date of 01/01/1948 and 6% average annual returns. The example is hypothetical and provided for illustrative purposes only.
Regardless of age, it makes sense for most investors to tap their Roth IRAs last. That’s because Roth IRAs are not subject to RMDs and withdrawals are tax-free.1 “Many retirees with Roth IRAs use the funds to cover larger one-off expenses in retirement—such as an extended vacation or home-improvement projects—because the withdrawals won’t add to their taxable income for the year,” Rob says. “Roth IRAs stand alone in terms of the tax flexibility they offer.”
There may be even more tactics (such as tax-loss harvesting) to manage your withdrawals effectively and tax-efficiently. Talk with your financial advisor or a tax professional to discuss your particular needs.
Challenge 2: Navigating a bear market
If there’s one thing retirees fear most, it’s a market downturn. “There’s nothing scarier than watching your portfolio plummet 20% or more in a single year,” Rob says.
At the same time, you don’t want to reduce your exposure to stocks so much that you inhibit future growth potential. Fortunately there are ways to insulate your savings from the effects of a major market decline while still leaving room for growth:
- Keep a year’s worth of living expenses in a relatively safe, liquid account. “You can spend from this account, reducing your need to pay close attention to monthly dividend or interest payments or income sources,” Rob says. “Replenish the account with regular income sources, such as Social Security, and periodic portfolio withdrawals.”
- Consider moving a portion of your savings into less volatile investments. Some assets, such as high-quality short-term bonds or short-term bond funds, tend to fare better when the market takes a dive. “You want to avoid having to liquidate your investments when the market is down,” Rob says. “Otherwise, you’ll have to sell a larger quantity of assets to meet your spending needs in those years, leaving you with fewer shares and limiting your portfolio’s ability to recover down the road.”
- Invest the rest for higher income and growth. “You’ll want to maintain stocks, even in retirement,” Rob says. They allow for potential compounding and may boost your savings over time.
- Remain flexible with your spending plan. If you can reduce spending or delay big purchases during a downturn, your portfolio will have a better chance of bouncing back.
Challenge 3: Managing unpredictability
So much of retirement planning relies on assumptions. How much income you’ll need. How much you’ll earn from your investments each year. How long you’ll live. “You can make educated guesses, but they’re just that—guesses,” Rob says. “And that makes it difficult to know how long your money will really last.”
For example, if you need more income than initially anticipated—such as to cover rising health care costs—how will that affect the longevity of your savings? If you rerun the numbers and discover that your savings are likely to fall short, how do you make ends meet without sacrificing your lifestyle in retirement?
It’s also possible that your portfolio may perform better than expected. In that case, you may be able to spend more. Still, it can be a challenge to know when it’s time to increase your spending.
“There are plenty of things you can do to accommodate a significant change,” Rob says. “But the challenge becomes figuring out what you should do—and that’s where it makes sense to seek outside help.”
Don’t go it alone
Creating a lasting retirement-income plan requires a fair deal of planning, organization and oversight to achieve optimal results. Fortunately, you don’t have to figure it out on your own.
“From traditional investment advisors to technology-based solutions, there are plenty of places retirees can turn for help,” Rob says. (see “Introducing Schwab Intelligent Income™,” below). “The important thing to remember is that the sooner you get a handle on your retirement-income plan, the more time you’ll have to make adjustments to help ensure your savings can go the distance.”
1You must be at least age 59½ and have held the account for at least five years to qualify for tax-free withdrawals.
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