The thought of transitioning from “saver” to “spender” can be challenging for new retirees. After decades of saving, determining how to convert that savings to an income stream requires careful consideration.

Setting a Withdrawal Rate

The retirement lifestyle you can afford depends not only on your assets and investment choices, but also on how you draw down your investment portfolio. Calculating an appropriate withdrawal rate is an essential part of retirement planning, but it presents several challenges. Take out too much, too soon, and you run the risk of draining your portfolio in your later years. Take out too little, and you may not enjoy your retirement years as much as you should.

One widely used rule of thumb states that withdrawing approximately four percent from a balanced investment portfolio each year should provide inflation-adjusted income for roughly 30 years. Some experts suggest that a higher withdrawal rate (closer to five percent) may be possible early in retirement if later withdrawals grow at a rate slower than inflation. Still, others believe that portfolios can last longer by “simply” freezing the withdrawal rate during years of poor performance.

It is worth pointing out that these rules of thumb all rely on historical data. And, as the investment industry is fond of reminding investors, past results are not a guarantee of future performance. That said, when making investment decisions, it’s important to use the best available information. There is a saying that, “history doesn’t repeat, but it often rhymes.” In other words, the future may not look exactly like the past, but historical patterns provide a strong basis for establishing how you should expect financial markets to perform over long periods of time.

There is no one-size-fits-all rule that works for everyone. When determining an appropriate withdrawal rate, you should take into account many factors, including:

  • Asset allocation,
  • Projected rates of return,
  • Annual income targets (accounting for inflation as desired) and
  • Investment time horizon.

Knowing Your Distribution Requirements

You cannot keep money in tax-deferred retirement accounts indefinitely. The law requires you to begin taking distributions — required minimum distributions (RMDs) — from traditional IRAs by April 1 of the year following the year you turn age 70½. For employer plans, RMDs must begin by April 1 of the year following the year you turn 70½ or, if later, the year you retire. In both cases, you are required to make these distributions regardless of whether you need the money or not. Roth IRAs are not subject to the lifetime RMD rules, making them an invaluable long-term savings tool.

Weighing Options for Annuity Distributions

If annuities are part of your retirement savings, at some point you'll need to consider your options for converting those savings into income as well.

You may choose to withdraw earnings (or earnings and principal) from the annuity. There are several ways of doing this. You can withdraw all of the money in the annuity (both the principal and earnings) in one lump sum, or over a period of time through regular or irregular withdrawals. By choosing to make withdrawals from your annuity, you continue to have control over the money you have invested within the annuity structure. However, if you systematically withdraw the principal and the earnings from the annuity, there is no guarantee that the funds in the annuity will last your entire lifetime — unless you have purchased a rider that provides guaranteed income payments for life.

A second distribution option is annuitization. If you select this option, the current value of your annuity converts into a guaranteed stream of payments. Upon annuitization the issuer of the annuity promises to pay a set amount on a periodic basis (monthly, yearly, etc.) for a set period of time (your life, you and you and your spouse’s life, 10-year certain, etc.).

Deciding when and how to begin pulling money from your annuities should include a close look at the types of accounts you have and the order in which you should begin drawing from those accounts.

Making the First Draw

Many people retire with assets spread across accounts that are:

  • Taxable (CDs, mutual funds, brokerage accounts),
  • Tax-deferred (traditional IRAs, traditional 401(k)s), and/or
  • Tax-free (Roth IRAs, Roth 401(k)s).

The decision of which type of account to draw from first is an important one, and the answer is the always popular, “it depends!” For retirees unconcerned with leaving an estate to beneficiaries, the answer is simple in theory:  taxable accounts, tax-deferred accounts and tax-free accounts, in that order. By using the tax-favored accounts last, you delay taxes owed on distributions as long as possible. This strategy keeps more of your retirement dollars working for you, which can help your assets last longer.

For retirees who wish to leave assets to non-spouse beneficiaries, the analysis is a bit more complex. In this scenario it is important to coordinate retirement cash flow planning with an estate plan. If you have appreciated or rapidly appreciating assets, it may be wise to withdraw from tax-deferred and tax-free accounts first. At your death, the holdings in a taxable account receive a step-up in basis, and do not require minimum distributions. This makes these assets attractive to those inheriting them, as they may reduce the tax bill associated with tapping into the assets.

Alternatively, if you intend to leave your entire estate to your spouse, it likely makes sense to withdraw from taxable accounts first. This is because spouses receive preferential tax treatment with regards to retirement plans. A surviving spouse can roll over retirement plan funds into his or her own IRA or retirement plan. These funds can then continue to grow tax-deferred, and distributions need not begin until the spouse’s own RMD date. This strategy can be particularly beneficial for a younger spouse who stands to inherit sizeable qualified retirement account assets from an older spouse.

The bottom line is that decisions about how to convert retirement savings to retirement income are complex and require careful consideration. Coordinating retirement cash flow planning with estate planning often provides the best result. Knowing how (and what) your assets can provide for you and your loved ones through your retirement and beyond often provides a measure of comfort as you navigate the transition.

Contact Michael Baker to learn more about this topic.
330.255.4326 |


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