You have worked and saved all your life, and now it’s finally time to retire and live off those savings. What is the best approach to maximize your retirement accounts like 401(k) and IRA to ensure you are not exposed to common retirement fears – running out of money?
The Critical Issue: Ensuring Your Money Doesn’t Run Out
While retirees may face different concerns than those still in the workforce – like healthcare and living on a fixed income – one of the most significant concerns is ensuring that your income does not run out.
“The biggest worry people seem to have is running out of money in retirement,” says Chad Parks, founder and CEO of Ubiquity Retirement + Savings in San Francisco. “The first step is to look at how much you want to withdraw from your retirement plan and ask yourself if this is your only source of income in retirement.”
In this regard, Social Security is a great retirement plan that ensures at least one source of income doesn’t run out. You will receive a check for life. That’s also part of the appeal of annuities, which can promise guaranteed retirement income as long as you live.
Your potential lifespan is an important consideration in any calculation as well. Since there is a good chance that one person in a couple aged 65 with average health will live to 92, making sure that the money lasts until age 95 or 100 is wise, not out of reach.
One way to avoid running out of money is to reduce what you need in retirement. For example, you might downsize your lifestyle to match a lower income. However, you can take steps before retirement to lessen the need to tap into retirement funds as well. For example, by paying off your mortgage or car loan while you are still earning, you will reduce what you need to pay later.
By lowering your income needs, you may also set yourself up to benefit from tax-free withdrawals of retirement funds.
Top 4 Retirement Withdrawal Strategies
As you consider what you need for retirement, don’t forget that you likely have a monthly paycheck coming from Social Security as well. From this income, you can work backward to figure out how much money you need each month.
These strategies can help you with retirement withdrawals to extend your savings and reach your goals.
1. The 4% Rule
The 4% rule is an old rule of thumb, but it remains a popular way to withdraw money in a way that statistically reduces the risk of running out of funds.
With the 4% rule, you withdraw 4% of your portfolio’s value in the first year of retirement. The dollar amount of this withdrawal is increased each year by the rate of inflation. For example, if you have a retirement nest egg of $500,000, your withdrawal in the first year would be $20,000, which is 4% of $500,000.
In the second year, the $20,000 withdrawal is increased by the inflation rate. If inflation is 3%, the withdrawal in the second year would be $20,600. If inflation remains at 3% in the following year, the withdrawal in the third year would be $21,218 – up 3% from the previous year’s withdrawal of $20,600.
The 4% rule actually applies to the amount taken in the first year only, but the amount withdrawn is adjusted every year by the rate of inflation to maintain the purchasing power of the amount withdrawn in the first year.
But
Is 4% the correct number for the first withdrawal?
Wade Pfau, PhD, a professor of retirement income and co-director of the American College’s Retirement Income Center at the American College of Financial Services, has consistently advocated for a withdrawal rate of less than 4% for years. At the beginning of the pandemic, he even set it at 2.4%.
According to Dr. Pfau, one of the leading scholars and thought leaders of the 4% rule, a 4% withdrawal rate decreases the likelihood of money lasting for the intended period of 30 years amidst low interest rates and high stock market valuations.
The downside: A very high withdrawal rate, combined with a downward market in the early years of retirement, can quickly deplete your retirement fund.
“With increased volatility, retirees may see more money being withdrawn from their portfolios in a bear market,” according to Julie Kolutchy, a wealth advisor at New England Investment and Retirement in Naples, Florida.
If you have to take money out when the market is down, you lose some ability to ride it back up, which can permanently reduce the lifespan of your retirement nest egg. This is also known as “sequence of returns risk.”
2. Fixed Dollar Strategy
In the fixed dollar strategy, retirees determine the amount they need to withdraw each year and then reassess that amount every few years. Future withdrawals can be lowered to match the decreased portfolio value, or they can be increased if investments rise in value.
“One of the benefits of the fixed dollar strategy is that retirees know the exact amount of money they will receive each year,” according to Kolutchy.
Downsides: “This strategy does not protect the retiree from inflation risk and faces the same disadvantages as the 4% rule when experiencing volatility,” she says.
3. Total Return Strategy
With the total return strategy, the goal is to stay fully invested as long as possible, particularly in long-term growth assets like stocks. Therefore, you’ll only withdraw 3-12 months’ worth of expenses and leave the rest in your retirement accounts. You will then tap into those accounts again when you need more.
“This strategy works well for retirees who can take on more risk and who may have larger plans for risk management,” according to Halley Brown London, CFP, with Motley Fool Wealth Management in Alexandria, Virginia.
If you can handle high-risk, high-return assets like stocks – and do not always need to sell them if the market goes down – you can endure market fluctuations to achieve a higher overall return. It also helps if you have more money in your retirement accounts, so any amount you take is a relatively small part of your assets, leaving the rest in the account to increase in value.
Downsides: This strategy can expose your portfolio to potential high gains as well as losses, and that may not be feasible for many retirees. If you need to tap into your accounts only when the market is down, you may have to sell or cut back on your living expenses.
“Ultimately, the total return strategy can prove to be a successful approach, keeping more assets invested for the long term, but it should be used for clients who have a good understanding of market performance and can handle volatility and sell assets even when the markets are down,” according to London.
4.
The Bucket Strategy
The bucket strategy divides the team from other strategies – where investment funds are kept in high-yield assets for longer periods while allowing you to withdraw funds to meet short-term needs.
Your investments are divided into three buckets based on when you need the money and are placed in different assets that fit that time frame and risk, as explained by London:
Bucket #1 contains the money you need within 6 to 12 months, and it is held in high-yield savings accounts or other quickly tradable accounts.
Bucket #2 contains the money you need during the 7 to 36 month period and can be invested in short-term bond funds or high-yield certificates of deposit.
Bucket #3 contains assets that you will not need for at least 24 months, allowing you to allocate at least a portion of it to higher-yield assets such as stocks.
When money is withdrawn from the first bucket, it is poured from the second or third bucket, depending on the performance of the assets in those accounts. By ensuring that your short-term cash needs are met, it allows the assets in the subsequent buckets a chance to grow.
Disadvantages: The bucket strategy may be a good balance among other strategies, but like most balances, it sacrifices some benefits of one strategy to gain some benefits of another strategy. For example, the total return strategy may give you the best chance for appreciation, but the bucket strategy provides you with more security today because you have locked in your cash needs while still offering some opportunities in the long term.
Other Factors to Consider
Two other factors should play a role in your planning: taxes and whether you are a woman.
Tax Implications
When considering these strategies, you will also want to look at the tax implications when withdrawing funds. Individual retirement accounts provide different tax advantages compared to Roth IRAs, for example. 401(k) retirement plans offer advantages that differ from IRAs as well as Roth 401(k)s.
For instance, it makes sense to withdraw money first from tax-deferred accounts like a Traditional IRA, since you will pay taxes on that money at lower rates. Then you might take money from a Roth account, helping you avoid a higher tax rate on your income.
“Usually, assets from the Roth are withdrawn last because they are tax-free on income when distributed,” according to Colucci.
By planning ahead, you can reduce the amount you send to the government and keep more of it in your own pocket. You might even be able to receive Social Security tax-free.
Required Minimum Distributions
Required Minimum Distributions (RMDs) represent the annual amounts that must be withdrawn from certain retirement accounts once the account holder reaches a certain age. In late 2022, Congress passed legislation that increases the age at which distributions must begin from 72 to 73. The age is set to increase again to 75 over the next decade.
The exact amount you will need to withdraw changes from year to year and is based on life expectancy projections and calculated using a table provided by the Internal Revenue Service. It is worth noting that Roth IRA accounts do not come with required minimum distributions for the account holder.
Retirement Planning as a Woman
Women are more likely to have to take steps that men do not take to ensure that their money does not run out. According to a review by compensation data company PayScale on the gender pay gap, in 2023, women generally earn $0.83 for every dollar earned by men. Lower earnings translate not only into a lesser ability to save but also reduce lifetime earnings, impacting Social Security payments.
Indicates
Kolluchi notes that women live longer than men, and therefore “women need to look for ways to extend their assets for longer.”
While Social Security offers spousal benefits that can reduce retirement inequality, it may not be enough to offset women’s lower lifetime earnings.
Thus, women should carefully consider their options. Are they willing to take on more risk in their portfolios? Do they have enough time before retirement to invest and grow the required assets?
Your situation will also depend significantly on whether you are single or married, as you may also be able to rely on your partner for planning and financial support.
Couples should consider their savings and retirement benefits and make decisions together, according to Parks, who notes that proactive planning can really help here.
“If one partner receives a pension, there may be a feature called a joint and survivor benefit that may be available in some plans,” he says. “This means that if the primary person in the pension plan dies, the regular payments continue as long as one spouse is alive.”
However, he notes that such a feature is likely to significantly reduce the monthly payments of the plan.
Conclusion
Whatever approach you take to withdrawals, ensure it aligns with your overall goals and needs, and remember to think long-term. Planning for future decades can be complex and requires specific skills, so it may be wise to hire an independent financial planner to assist you in managing the process. Here’s how to find an advisor who works in your best interest.
Source: https://www.aol.com/retirement-withdrawal-strategies-4-ways-174333722.html
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