Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act, a new law governing retirement savings. The SECURE Act may impact investors nearing- or in retirement, new parents, small business owners and employees. For more information about the SECURE Act, please read this article or speak with your financial consultant.
After years of diligent saving, many retirees may be unsettled by the notion of actually tapping their portfolios. When should you start? How much is too much? What if you outlive your money? These are legitimate concerns, but by focusing solely on drawdowns, you could be overlooking other risks to the longevity of your savings.
Let’s take a look at three common mistakes that can negatively impact your retirement income—and what to do about each.
Mistake #1: Selling assets in a downturn
If your first few years of retirement coincide with a market decline, you’ll probably need to sell more of your assets to fund the same withdrawal—leaving you with fewer shares and limiting your portfolio’s ability to recover during a potential market rally.
If the decline is particularly steep or lasts for an extended period, it’s even harder to bounce back (see “Timing is everything,” below).
Timing is everything
This chart looks at how two retirees with identical portfolios and annual withdrawals could see very different results depending on when a market downturn occurred.
This chart is hypothetical and for illustrative purposes only. Both investors had a starting balance of $1 million, took an initial withdrawal of $50,000 and increased withdrawals 2% annually to account for inflation. Michael’s portfolio assumes a negative 15% return for the first two years and a 6% return for years 3–18. Linda’s portfolio assumes a 6% return for the first nine years, a negative 15% return for years 10–11 and a 6% return for years 12–18.
So, what’s an investor to do? I suggest two courses of action:
- Adjust your allocation: Consider moving a portion of your assets into investments that are more likely to weather market disruptions. We suggest that retirees keep a portion of their retirement portfolio in cash or cash alternatives and use that to help fund expenses. Then, consider allocating some to less-volatile investments, such as high-quality short-term bonds or short-term bond funds.
- Stay flexible: Regardless of when a downturn occurs, it’s important to remain flexible with your spending plan. If you’re able to reduce your spending and/or delay large purchases, your portfolio will tend to have a better chance of enduring a decline.
Mistake #2: Collecting Social Security too early
It’s the age-old question: When should I start collecting Social Security? Many Americans opt to collect as soon as they become eligible at 62, but taking benefits before you reach full retirement age (from 65 to 67, depending on your birth year) means settling for smaller payments—for life.
If you’re able to wait even a few years longer, you stand to receive a much larger monthly check (see “Delayed gratification,” below).
Individuals who collect Social Security beginning at age 62 receive 25% less in monthly benefits than if they had waited until full retirement age (FRA)—and roughly 43% less than if they had waited until age 70.
Source: Social Security Administration. Benefits are based on FRA for individuals born from 1943 through 1954 and assume no inflation increases. For illustrative purposes only.
Waiting to collect can also help extend the life of your portfolio. True, you’ll have to rely on your savings alone if you retire several years before you start collecting Social Security, but the increased income that comes with deferral—which is guaranteed for as long as you live—can help preserve your portfolio later.
Furthermore, unlike most other retirement income sources, your Social Security benefit is adjusted upward in response to inflation—so bigger checks mean bigger cost-of-living adjustments. Of course, delaying benefits is feasible only if you don’t require the income right away, so discuss your income needs and longevity expectations with a financial planner.
Mistake #3: Creating an inefficient distribution strategy
When it’s time to turn your retirement savings into income, it might not be as simple as selling investments and pocketing the proceeds. Rather, using your assets to support you in retirement should take not only your income needs into account but also timing, taxes, life expectancy and account types.
Keep a close eye on taxes—especially once you reach age 70½. That’s when the required minimum distributions (RMDs) the IRS obliges you to take from your 401(k)s and SEP, SIMPLE and traditional Individual Retirement Accounts (IRAs) kick in.
For example, if RMDs push up your taxable income, not only could you pay more on your regular income and Social Security benefits but you might also owe taxes on the long-term capital gains and qualified dividends in your nonretirement accounts.
This is where a distribution strategy can help. For example, some retirees might choose to take withdrawals from tax-deferred accounts like traditional IRAs prior to age 70½—when they have more flexibility to decide how and when to take distributions—in order to help reduce the size of their portfolios and thus the size of their RMDs, as well as manage their overall tax bill.
Keep in mind that withdrawals from tax-deferred accounts prior to age 59 ½ may be subject to an additional 10% penalty so it’s usually best to try to avoid withdrawals prior to that age.
Other retirees may opt to convert some of their retirement assets into Roth IRAs,1 which are not subject to annual RMD requirements.
Whatever you decide, make sure to work with a financial planner and tax advisor to think through the details of your distribution plan.
Rob Williams, CFP®, CRPC®, is vice president of financial planning at the Schwab Center for Financial Research.
1A Roth IRA conversion results in taxation of any untaxed amounts in the traditional IRA and requires a five-year holding period before earnings can be withdrawn tax-free; subsequent conversions will require their own five-year holding period. In addition, earnings distributions prior to age 59½ are subject to an early-withdrawal penalty.