Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act, a new law governing retirement savings.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.
When investors think about retirement plans, many focus on socking 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, there are general principles that apply to any retirement withdrawal strategy. It’s just a matter of drawing up a budget that reflects all of 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.
Use guaranteed income to cover essential expenses
Social Security, pension payments, annuities1, 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 essential expenses like housing, car loans, food and utilities.
Avoid tapping your more volatile investment assets to cover regular costs when you could be using income from more predictable sources supplemented by cash balances or a reserve of lower-volatility investments.
Selling volatile assets can be particularly costly when the market is down.
Fund discretionary expenses with fluctuating income
Stock dividends, distributions from mutual or exchange-traded funds and proceeds from selling investments are less reliable than the predictable income sources cited above. This makes them a better fit for nonessential items, like vacations or gifts to a charity or grandchild.
Generate cash flow when you rebalance your portfolio
Selling investments 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 the portfolio. For most retirees, it may make sense to decrease your risk and exposure to stocks as you age, 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 can drift away from target allocations as certain asset classes rise or fall, leaving them over- or underweight in certain areas of the market.
To help remedy this imbalance during periods when stocks rise in value, you can sell from the stock portion of your portfolio to generate the cash you need and get your portfolio back on target. (See “Selling investments” below for more information.)
At the same time, you can use annual rebalancing to generate cash needed to support other income sources. In down markets, you might tap investments that held their value or rose in value.
With an eye on the market, the natural process of rebalancing helps you know what to tap when.
Remember that rebalancing does not protect you against losses or guarantee that you’ll meet your goals.
One mistake many retirees make is to rely only on investment income to support retirement spending and not on all of the source of returns, 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 you could tap: interest, dividends, capital gains and stable assets such as cash in your portfolio.
Keep these points in mind as you create your own distribution plan, and 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 your portfolio in a balanced way, 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.
When it comes to 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 401(k).
That’s assuming you have enough retirement savings in taxable brokerage accounts and haven’t yet reached age 70½, 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 you need the money sooner. If that is the case, you might want to start taking distributions before you reach age 70½.
Otherwise, when you start taking RMDs after age 70½, you might be bumped up to a higher tax bracket. Withdrawals 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. Talk with your advisor or a tax professional to time your retirement income distributions wisely.
1 Annuity guarantees are subject to the financial strength and claims‐paying ability of the issuing insurance company.