Saving money for retirement is only part of ensuring a financially secure future. The other half involves making smart decisions about withdrawing that cash.
“There is no easy straightforward answer,” says Chad Parks, founder and CEO of Ubiquity Retirement + Savings, a firm that provides 401(k) accounts to small businesses. Without knowing how long someone will live, it’s impossible to say definitively how much a person can withdraw from retirement accounts each year without running out of cash.
Instead, finance experts say there are a handful of retirement distribution strategies that can be used to stretch money further for a long retirement, and these can be combined and changed over time.
“Typically, we do this distribution planning once a year,” says Kara Duckworth, certified financial planner and managing director of client experience for Mercer Advisors in Newport Beach, California. Current market conditions, tax rates and a person’s expected longevity are all factors that need to be considered.
[Read: How Many Retirement Accounts Should You Have?]
Rather than pick a single method to use throughout retirement, talk to a financial advisor about how to make the following retirement withdrawal strategies work together.
— Use the 4% rule.
— Withdraw a fixed percentage.
— Take fixed dollar withdrawals.
— Limit withdrawals to income.
— Consider a total return approach.
— Create a floor.
— Bucket your money.
— Minimize mandatory distributions.
— Use account sequencing.
Use the 4% Rule
Financial advisor William Bengen is credited with originating the 4% rule, which many people use to guide their retirement withdrawals. The rule determined that withdrawing 4% from a retirement fund in the first year, followed by inflation-adjusted withdrawals every year after, should ensure money is available to sustain a 30-year retirement.
It’s been more than 25 years since Bengen created his rule, and current advisors say people shouldn’t be too wedded to the idea of withdrawing 4%. While the concept is sound in theory, the right percentage for a retiree should be customized for a person’s age and life expectancy.
“I’m not sure 4% is the gold standard of safety anymore,” Duckworth says. Withdrawing too much, particularly in periods of a down market, could deplete an account well before the end of retirement.
Withdraw a Fixed Percentage
Some people mistakenly believe the 4% rule is a fixed percentage distribution strategy, according to Taylor Hammons, head of retirement plans at Kestra Financial in Austin, Texas.
However, the 4% withdrawal is only for the first year. After that, the amount must be adjusted each year based on the rate of inflation, and this could result in a different percentage being withdrawn. For example, a retiree with a $1 million nest egg would withdraw $40,000 the first year. The next year, they would adjust that $40,000 to reflect the rate of inflation and take out that amount.
Meanwhile, a fixed percentage distribution system takes out a specific percent of the balance — whether that is 4% or another amount — regardless of inflation or other factors. Its simplicity can make it attractive to retirees, but it can also be risky if your portfolio doesn’t perform well.
“If you have a (market) downturn, you could have some issues,” Hammons says.
Take Fixed Dollar Withdrawals
Some seniors treat their retirement accounts like piggy banks, withdrawing money whenever it is needed. However, a smarter approach is to make systematic withdrawals of the same amount every month, quarter or year. Of these, monthly distributions typically make the most sense.
Some mutual funds and other investments, such as annuities, promise regular payments of a specific amount. Retirees can also decide to take out a specific amount from their own retirement funds.
This retirement distribution strategy can provide reliable income in retirement, but it doesn’t take into account a fund’s performance. Taking out a fixed dollar amount each month or year can eat away at an account’s principal.
Limit Withdrawals to Income
Another way to approach retirement fund disbursement is to limit withdrawals to income generated by investments. That means taking out dividends and gains each year but leaving an account’s principal intact.
This method ensures an account doesn’t run dry since the principal isn’t touched. However, the downside is that annual income can be unpredictable. What’s more, unless the principal amount is sizable, it may be difficult to live on dividends and interest alone.
“The problem is that it doesn’t work for people with smaller accounts,” Hammons says. If someone has a $100,000 balance and an annual return of 6%, that only provides $6,000 for the year. Unless someone has substantial retirement income from other sources, such as a pension, limiting withdrawals to income may not be realistic in this scenario.
[Read: 8 Ways to Overcome Financial Difficulties in Retirement.]
Consider a Total Return Approach
While limiting withdrawals to income feels safe, it may not be practical for everyone. Dipping into an account’s principal may be unavoidable for some retirees.
One way to do that is as part of a total return approach to retirement distribution. A total return strategy takes into account dividends, interest, growth and principal for purposes of taking systematic withdrawals. These withdrawals are often used to create a predictable paycheck each month based on the 4% rule or a similar percentage of the total fund.
Although distributions from a retirement plan may equal the same percentage each month, the source of the money can vary. A financial advisor can help determine which funds to withdraw money, based on fund performance, and then rebalance the portfolio as needed.
Create a Floor
Some retirement accounts provide guaranteed income. These include Social Security, pensions and annuities, and retirees can count on them to deliver cash on a regular schedule.
A flooring strategy involves building up enough of this guaranteed income to meet basic needs. One way to do that is to purchase an annuity with an income rider that is inflation-adjusted.
“There are a lot of lifetime income products coming into the market nowadays,” Parks says. These include longevity annuities that don’t start paying out until later in life — often after age 75 or 85 — and can be affordable if purchased at a younger age.
Another option is delaying the start of Social Security benefits. For each year you delay the start of benefits past your full retirement age until you reach age 70, you’ll get an 8% boost in your monthly Social Security payments. However, workers younger than age 50 may want to leave Social Security out of the equation until issues surrounding the long-term solvency of the program are resolved.
Regardless of its makeup, a strong financial floor provides peace of mind that no matter how the markets perform, a person will be able to pay necessary expenses.
Bucket Your Money
For funds that don’t provide guaranteed income, such as 401(k)s and IRAs, a bucket strategy ensures some money is protected for short-term use while other money is allowed to grow for long-term use.
“I love the bucket strategy,” Hammons says. “It’s (addressing) what the other strategies don’t solve for.” Specifically, it asks retirees to consider how they plan to use their money and when they will need it.
While the details can vary depending on a person’s needs and life expectancy, a typical strategy might use three buckets.
The first bucket holds money needed within the next three years in cash or bond funds. There, the money won’t see significant gains, but the stability of these funds should insulate it against losses. Money that will be needed in three to 10 years may be put into a mix of stocks and bond funds where it may see more moderate growth. Funds not needed for 10 years or more may be invested more aggressively in growth funds.
“People don’t appreciate that they are still a long-term investor,” Hammons says. Retirees may spend decades in retirement, and money in the third bucket should be invested with that long time horizon in mind.
Using a bucket strategy also helps ensure retirees won’t have to pull money from stocks in a down market. If a recession is looming, it may make sense to put even more money in cash and bond funds.
Minimize Mandatory Distributions
Having control over when and how you use your retirement money is a key component of stretching funds across a long retirement. However, traditional 401(k) accounts and IRAs have required minimum distributions, known as RMDs. These distributions have the potential to significantly increase a retiree’s taxable income.
RMDs must begin at age 72 and failure to withdraw the designated amount could result in a hefty tax penalty. Some people may want to reduce or eliminate RMDs by converting money from traditional retirement funds to Roth accounts.
“If you have a Roth IRA, chances are you’d want to let that ride for as long as possible,” Parks says. “That might be the last bucket you tap into.”
Money in Roth accounts grows tax-free and can be withdrawn tax-free. However, tax is due on any amount converted from a traditional fund to a Roth account. New retirees who delay the start of Social Security may find they have several years of low income early in retirement, which may be a good time to complete a conversion.
Use Account Sequencing
When it comes time to make systematic withdrawals, people should be strategic about where they pull money. “What’s the most efficient way to get to that target number,” Duckworth says.
Known as account sequencing, the optimal order for withdrawing funds is the one that will minimize taxes and allow money in long-term buckets to continue to grow. A person’s tax bracket can play a significant role in when to withdraw money from tax-advantaged funds.
The best approach for many retirees may be to withdraw cash from a combination of savings and investment accounts. Many advisory firms use software to help clients determine the best method and order to dip into funds.
[See: 10 Retirement Lifestyles Worth Trying.]
Match the Right Distribution Method to Each Retirement Account
Retirement withdrawal strategies can be applied across a variety of investment vehicles: 401(k) accounts, IRAs, annuities and life insurance, among others. However, each investment has its own withdrawal rules that can and should affect how you treat money in that account.
For example, some people may prefer to take money from a 401(k) before beginning Social Security. There are no limitations on withdrawals made from a 401(k) after age 59 1/2, and by using money from these accounts first, it can allow Social Security benefits to be deferred and grow until age 70.
Likewise, if someone has both traditional and Roth accounts, they need to be smart about where they pull their money. If someone has reason to believe their tax bracket will be lower later in retirement, using money from a Roth account first may make sense.
Don’t forget to also consider other assets that may impact retirement distributions. “I have clients who are now looking at reverse mortgages,” Duckworth says. Tapping into home equity in this way could limit the need to pull money from taxable sources.
Retirement distribution strategies can be daunting for many retirees to navigate. However, with professional guidance, selecting the right combination of methods can help ensure retirement accounts don’t run dry.
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9 Retirement Distribution Strategies That Will Make Your Money Last originally appeared on usnews.com
Update 02/03/22: This story was published at an earlier date and has been updated with new information.
