For some retirees, making the transition from saving and investing to building a retirement portfolio and living off that savings can be disorienting. How much can you spend each year? Will you have enough? Should you rely solely on investment income or also tap growth in your portfolio and sell some investments?
Starting with a sensible, sustainable income plan can help.
Create your own retirement cash flow
But, what’s a general ball-park figure? Some retirees start with general guidelines, such as the so-called 4% rule. Following this guideline, you would withdraw 4% of your portfolio in the first year of retirement and then increase that initial amount in line with inflation each year over a 30-year retirement.
The 4% rule is just a rough guideline. People who expect a shorter retirement might consider larger withdrawals, while those with a longer time frame should take less. No matter how reasonable your assumptions, though, actual future returns and inflation rates will vary. Whether you have a precise spending plan or use a general starting point like the 4% rule, it’s a good idea to stay flexible.
For example, in years when the markets are down, you may want to scale back on your withdrawals. In up years, you may feel freer to spend a little bit more. That said, if you plan on an initial withdrawal rate of somewhere between 3% and 5% of your portfolio’s value in the first year of a 30-year retirement, there’s a higher probability that your money will last.
Even better, working with a financial advisor to create a personalized investment and income plan is always a great place to start. Enjoying what you saved is critical, and starting with a plan to help you feel comfortable with what you’re spending makes sense.
Every few years afterward, meet with your advisor and update your plan, portfolio, and spending rate. As you move through retirement, and your life and markets change, the amount you can spend each year as a percent of your portfolio will likely change as well.
After you’ve determined a reasonable portfolio withdrawal rate, follow these simple guidelines:
1. Set aside a cash cushion
Consider setting 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 retirement income, such as Social Security, pensions and so on. Place next year’s spending 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)
View this balance as “money spent,” outside your portfolio, if you can. It’s your next years’ worth of retirement income.
2. Manage your retirement portfolio sensibly
- Invest the rest in a diversified portfolio, for a combination of income and potential growth, based on your time horizon and risk tolerance.
- Diversify your portfolio across and within asset classes.
- Within this portfolio, we suggest keeping the equivalent of two to four years’ worth of spending in some less aggressive investments like cash investments, CDs, short-term bonds or bond funds with maturities matching when you may need the money. These investments can provide stability and can be tapped, if needed, instead of selling investments held for higher income or growth in a down market.
In the event of a bear market, you can cover expenses with these investments instead of selling stocks or more aggressive investments. For most retirees seeking to use their savings to support their spending, not other goals such as leaving money behind, we suggest no more than 60% of the portfolio in stocks and no less than 40% in bonds and cash at the beginning of retirement. Adjust that mix through retirement depending on your short-term needs, time horizon, and risk tolerance.
3. Boost your potential returns by investing tax-efficiently
- Every dollar you keep after fees and taxes is a dollar you can use to improve your retirement.
- We suggest that investors keep tax-efficient investments in a traditional brokerage (aka. taxable account). This includes stocks held longer than one year, tax-managed funds, index funds, and qualified-dividend-paying stocks, as well as municipal bonds (if they make sense for your tax bracket).
- If you have less tax-efficient investments, consider holding them in tax-deferred or tax-free accounts, such as an IRA, Roth IRA, or 401(K). This includes stocks held one year or less, actively managed funds, and higher-yielding taxable bonds.
Determine your retirement income sources
Once you’ve figured out how much you need from your portfolio, then how you’ll invest, the next question is: Where should the money come from?
Many retirees say they prefer not to spend “principal.” However, it’s helpful to ask, what we mean by “principal?” Growth in the portfolio in the form of capital gains are an important source of return¬¬ –and potentially cash flow– so it makes sense to have a broader conception of income.
It may help to think of principal as your original savings –your original nest egg– not continued growth from your portfolio. We believe that most investors should use every source of return from your portfolio, including but not limited to interest and dividends, to create your retirement cash flow.
What are steps you can take to generate the cash you need?
Dividends and interest versus selling shares. Over time, your portfolio withdrawals will likely come from a variety of sources—that is, a combination of interest, dividends, and proceeds from the sale of appreciated assets. Consider having interest and dividends for individual securities and distributions from mutual funds held in taxable accounts and automatically moved, when you need them, into a bank account. Interest, dividends and mutual fund distributions are already taxed in taxable accounts when you receive them, and the income can support a portion of your spending while limiting the need to sell shares or track the cost basis or tax implications of reinvested distributions or income.
Bonds maturing in the coming year. Consider bonds maturing within the next 12 months as part of your current-year cash flow, before liquidating other assets at a taxable gain. If you’re holding such bonds in a taxable account, you shouldn’t have to worry about unrealized capital gains, as any gains are likely to be relatively small.
Which investments should you sell? If your annual spending exceeds Social Security, pensions, interest income, dividends and mutual fund distributions, and maturing bonds, a sound approach is to generate additional cash through periodic rebalancing. Consider rebalancing a few times a year to bring your portfolio back to your target asset allocation. As you reallocate your assets, you can take out the cash you need.
For example, if your target allocation is 40% stocks and 50% bonds—but your portfolio drifted to 45% stocks and 45% bonds (with 10% in cash for both)—you could sell a portion of your stock allocation, reallocate what was left to bonds until you were back on target, and generate the cash you need.
Source: Schwab Center for Financial Research; Note: Though it’s generally recommended that you shift to a more conservative investing approach during retirement, your asset allocation still depends on your own circumstances and tolerance for risk. For illustrative purposes only.
Taxable versus tax-deferred accounts. In general, it’s often better to sell long-term investments held in taxable accounts instead of taking money from tax-deferred accounts before you have to.
Withdrawals of pre-tax contributions and income 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 or 401(K) early means losing opportunities for tax-deferred compound growth.
However, there are possible exceptions to this general rule: If your IRA or 401(K) balance is very large, you may want to draw from it before the age of 72 (70½ if you turned 70½ in 2019 or earlier), when required minimum distributions (RMDs), dictated by the tax law and the IRS, begin. (More on those below.) A sound tax-management strategy may be to start distributions earlier to smooth out your tax bill.
Also, for estate-planning purposes, your taxable estate includes your IRA balance and 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 your beneficiaries will be able to take distributions tax-free. Distributions from a Roth IRA are tax-free if you take them in retirement as well.1
Finally, if you had the foresight to accumulate savings in a Roth IRA, it gives you flexibility to balance withdrawals been traditional brokerage accounts, traditional IRAs and Roth IRAs as needed. Withdrawals from Roth IRAs are tax-free, providing considerable flexibility to manage your taxes if you have a large expense in a single year (say, for example, a major health-related cost) or work with a tax advisor each year to manage your tax bill.
There may be other factors to consider when building your income plan.
Required minimum distributions. Once you reach age 72 (701/2 if you turned 701/2 before 2020), the IRS requires you to take money out of your retirement accounts (except Roth IRAs), known as required minimum distributions (RMDs). If you don't, you could face a tax penalty. You can use an RMD calculator to calculate how much you should take.
Withdrawals from traditional IRAs and 401(k)s will need to be considered first—at least up to the amount of the RMD—or you will face a 50% penalty on what you should have withdrawn under the RMD formula.
Tax bracket ramifications. Consider ways to manage your tax bracket. For example, before your RMD age, you could consider taking just enough from your traditional IRA or 401(K) to keep you in the 15% tax bracket.
That could reduce the potential tax hit of 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.
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 12 months or less in a traditional brokerage (i.e. not tax-deferred accounts) until you’ve held the position for at least one year and one day from the original date of purchase, in order to qualify for the capital gains tax rates.
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. Talk to your tax advisor to see if any of these circumstances apply.
Finding the most tax-efficient withdrawal strategy can be challenging. Work with a tax professional each year to create the most efficient strategy for you.
1 If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties.