YOU'VE WORKED HARD, SAVED, INVESTED—all with the goal of having enough to live the retirement life you want. So the day is approaching, and you’re looking at the balances of your various accounts and thinking: Now what?
How much of your savings can you afford to spend if you want that money to last as long as you live? Which accounts should you consider drawing from first—your 401(k), your IRA, your taxable accounts?
You may have heard some broad guidelines about the “right” amount to withdraw each year, and the optimal order for tapping your various sources of income. While there are often kernels of truth in these rules of thumb, they generally gloss over the fact that everybody’s retirement is different—and much too important to be guided by a formula. “You need to come up with a plan for drawing down your income that’s based on your own unique priorities and goals,” says Ben Storey, director, Retirement Thought Leadership at Bank of America. “Creating that plan requires you to be thoughtful about what your expenses are going to be and about how you’ll allocate your resources.”
As you consider your personal equation for drawing down your retirement income, three primary questions are worth asking:
1. How much can I spend each year without jeopardizing my savings?
“The younger you are, the lower the percentage you’ll be able to spend each year if you want your savings to last throughout your lifetime.”—Ben Storey, Director, Retirement Thought Leadership, Bank of America
According to one oft-quoted rule of thumb, retirees should look at tapping into about 4% of their wealth annually. But that’s just a rough guideline, and one that doesn’t take into account variables such as the age at which you’re retiring and whether your income needs will change as you age, Storey says. “The younger you are, the lower the percentage you’ll be able to spend each year if you want your savings to last throughout your lifetime,” he says.
Because the likelihood of your money lasting depends on a delicate
balance between the rate at which your investments appreciate and the
rate at which you withdraw income from them—to say nothing of
inflation—your withdrawal rate is in some ways a reflection of your
confidence that your investments will continue to grow, or at least
not shrink relative to your withdrawals. If you think your money might
not last, and you're comfortable investing more aggressively, you
might decide to take a little more income each year. On the other
hand, if you desire less risk, you might opt for a lower withdrawal
rate. It is important to remember that investing involves risk, and
there is always the potential for losing money when investing in
Other factors may come into play as well. Some years you might plan to withdraw more in order to realize a long-cherished goal, like travel, for instance. Or you might have health care needs that dictate a higher spending rate. Your plans should be flexible enough to accommodate a variety of needs at different times.
2. What’s the order in which I should tap into my retirement accounts?
In this case, the conventional wisdom goes that you should withdraw from your taxable accounts first, then tax-deferred, then tax-free. That’s because the money you take from a taxable account (such as a brokerage account) is likely to be taxed at the rate for capital gains or qualified dividends, which varies depending on your tax bracket. It’s generally a lower rate than what you’d pay on ordinary income from 401(k)s, traditional IRAs and other tax-deferred savings. Tapping the taxable accounts first gives the other accounts the potential to continue growing, shielded from current taxes.
Tapping taxable accounts first gives the other accounts the potential to continue growing, shielded from current taxes.
But when you reach age 72, you’re legally obligated to take annual required minimum distributions, or RMDs, from certain tax-deferred accounts. However, if you are still working at age 72, you may not have to take annual RMDs from your employer’s qualified retirement plan accounts until the year you retire.1 RMDs are one reason to consider drawing from those accounts before taking federal tax-free qualified distributions from a Roth IRA. Roth IRAs don’t have RMDs, so you can keep money—and potential growth—in your account. What’s more, if there’s anything left over in your Roth IRA, it can be passed on to your heirs, who may be able to draw federal (and potentially state and local) tax-free income from it during their lifetimes.
While the guidelines for withdrawing income offer a reasonable starting point, Storey says, you’ll also need to look at your unique situation. “It’s helpful to have some flexibility in the way your income might be taxed,” he says. For example, if for some reason you were going to be in a higher than usual tax bracket one year—if you realized a significant gain from selling a business, say—you might like to have the option to draw federal (and potentially state and local) tax-free income from a Roth IRA.
3. When should I claim Social Security benefits?
"I worked with a couple recently who could have been receiving an additional $1,400 a month in spousal benefits for four years. That adds up."—Ben Storey, Director, Retirement Thought Leadership, Bank of America
Delaying the start of your benefits until age 70 may give you a
larger monthly payment than if you claim them earlier. But, Storey
notes, “after considering all of their options, some people might
decide not to wait.” If you have a health condition that could limit
your life span, for instance, it could make sense to start drawing
your Social Security income immediately. And depending upon your
situation, drawing this income sooner could help you cover essential
expenses during retirement, limiting the need to tap other savings.
Complex rules about spousal benefits could also come into play, he
adds. “I worked with a couple recently who could have been receiving
an additional $1,400 a month in spousal benefits for four years,” he
says. “That adds up.”
As you work out a plan for drawing down your retirement income, “it’s important to work with your financial advisor and your tax advisor to know all your options, and to take everything about your personal situation into account,” Storey says. “You can look at rules of thumb to get a general idea, but you’re different from anyone else, and your differences need to be factored into any thoughtful decision.”
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1If you were age 701/2 or older as of 12/31/2019, you would be required to take a required minimum distribution (“RMD”) for 2019. Effective 1/1/2020, in accordance with new legislation, the required beginning date for RMDs for individuals who turn age 701/2 on or after 1/1/20 is age 72. You may defer your first RMD until April 1st in the year after you turn age 701/2 or 72, as applicable, but then you’d be required to take two distributions in that year.
Neither Merrill nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult you legal and/or tax advisors before making any financial decisions.