Retirement planning is important if you want to retire comfortably and achieve your retirement goals. A key part of retirement planning is deciding between which retirement withdrawal strategies i.e. which is the best for you and how different factors affect your retirement savings.
This small guide on retirement distribution strategies is a help to make you choose the best withdrawal strategy and make the most out of your retirement income.
Retirement Income Sources
When you are in retirement, you are probably generating income through these common retirement income sources.
- Social Security
- 401(k) plan or similar defined contribution accounts
- Taxable investments
- Individual retirement accounts (IRAs)
- Employment or self-employment income
- A health savings account (HSA)
- An annuity
4 Factors That Affect Your Retirement Income
Before you choose a retirement withdrawal strategy, you need to consider the following factors that affect your retirement savings.
- Social Security and pension benefits: You can take your Social Security benefits when you reach the full retirement age of 67 years. You can also take early benefits at age 62. But, if you take the benefits early, your monthly benefits are reduced. If you wait until the full retirement age, you’ll receive 100% of your monthly benefit. Moreover, if you delay taking your benefits past your full retirement age, you’ll receive increased benefits until age 70, after which the benefits stop increasing, even if you decide not to take them. If you’re eligible for a pension, figure out what type of survivorship option to select, when to start taking the pension, and how to withhold taxes. Additionally, decide on how to maximize your pension payouts – lump sum or annuities – as they both affect your retirement income.
- Portfolio diversification: You should have a variety of income sources in your portfolio if you want to get the most out of your funds. Invest in interest-bearing assets and also have non-correlated investments, such as stocks and bonds. While creating your portfolio, consider your age when investing. You do not want to rely solely on stocks and gravely hurt your financial situation when there is a drop in the market.
- Life expectancy: The Social Security Administration stated that the average life expectancy for a woman who is 65 years old today is 86.5 years and 84 years for a man. And, 1 out of 7 people will live to be age 95. If you are retiring at age 65, you need to make your retirement saving last for another 20 or 30 years. Your living expenses and taxes are not the only costs you need to consider. Healthcare costs are a major expense and they increase as you age.
- Taxes: Many retirees owe taxes on their Social Security benefits, pension or annuity payments, and/or even on the money they withdraw from their retirement savings accounts (traditional 401(k) or IRA). When you’re budgeting for retirement, determine how much you will pay annually in taxes so that you know how much money is available to you when you retire.
Retirement Withdrawal Rules
There are different rules for different types of retirement savings account regarding withdrawal age and Required Minim Distributions (RMDs). For example, withdrawals from 401(k)s are treated very differently than those from Traditional and Roth IRAs.
When can I start withdrawing money from my IRA?
You can withdraw money from your IRA (penalty-free) when you turn 59 ½ years old. Early withdrawals are also allowed, but it will cost you a 10% early withdrawal penalty unless you qualify for an exception.
When do I have to start making withdrawals from my IRA?
You need to start withdrawing from your traditional IRA when you reach age 72 ½ unless you’re still employed. The amount you need to withdraw is called required minimum distribution (RMD).
You can withdraw more than the RMD, but these withdrawals made from a traditional IRA are taxable. However, if you don’t take the RMDs, you are liable to pay 50% excise tax.
However, Roth IRAs don’t require withdrawals until the account holder dies. Since contributions in your Roth IRA are made with after-tax dollars, your money grows tax-free, and your withdrawals in retirement aren’t taxed.
When can I start withdrawing money from my 401(k)?
You can start withdrawing penalty-free money from your 401(k) when you turn 59 ½. You can also withdraw early, but you will have to pay an additional 10% early withdrawal tax penalty unless you are eligible for an exception.
When do I have to start making withdrawals from my 401(k)?
When you turn 72 ½, you have to take RMDs from your 401(k), unless you are still working. Your RMDs are taxed as ordinary income.
|Retirement Account||Age at which you can start withdrawing money Tax-free||Age at which you need to start taking money according to required minimum distribution (RMD)|
59 ½ years old
72 ½ years old unless you’re still employed
59 ½ years old
59 ½ years old
72 ½ years old< unless you’re still employed
*If you take widrals before you are 59 ½ years old then you need to pay an additional 10% early withdrawal tax penalty
Retirement Withdrawal Strategies
Whether you’re invested in an IRA, a 401(k) or another type of plan, you need to design a withdrawal strategy to provide the income you need to fund your retirement. Consider these 5 withdrawal strategies:
- The 4% rule withdrawal strategy
- Fixed-dollar withdrawal Strategy
- Fixed-percentage withdrawal Strategy
- Systematic withdrawal Strategy
- Buckets withdrawal strategy
The 4% rule withdrawal strategy
This is the most common of all retirement withdrawal strategies. In the 4% rule, you withdraw 4% of your retirement savings in the first year of your retirement. In the next few years, you continue to withdraw 4%, making sure you scale up appropriately to factor in inflation.
This simple method is considered safe as it keeps your buying power at pace with inflation. However, with rising market volatility and increased interest rate, you are at risk of running out of money. Also, this rule doesn’t provide the flexibility to adjust your withdrawals based on the performance of your investments.
Bucket withdrawal strategy
The bucket strategy comprises splitting your savings based on your expenses into different accounts. For example, in your savings account (first bucket), you keep your living expenses for a year and a few months’ worths of the emergency fund. In fixed-income investments (second bucket), you can keep a couple of years’ worth of living expenses. The rest of your savings is retained in your retirement accounts or investment accounts (third bucket).
The best part of this approach is that you use your savings account for your living expenses, and refill this bucket with money from the other two buckets. To refill, you either sell the stocks when the market is up or sell you fixed income securities when they have performed well. If both stocks and bonds are not performing, you continue to draw from your savings.
This withdrawal approach allows you to have more control over your investments and help your account balance grow over time. but, this is a time-consuming process, and you may need to use another method to figure out how much you can afford to spend each year.
Fixed-dollar withdrawal strategy
In the fixed-dollar strategy, you withdraw a fixed amount over a specific period of time. You determine how much you need to withdraw each year and then reassess that amount every few years. The withdrawal amount can be increased or decreased to match the value of your investment portfolio. Although this approach allows you to determine the amount to withdraw based on your budget in your first year of retirement, it has substantial downsides. Firstly, if you don’t increase your withdrawal amount, your buying power will reduce because of inflation. And if you increase your fixed-dollar amount, you are at risk of running out of money too soon in retirement.
Fixed-percentage withdrawal strategy
In this type of withdrawal strategy, you withdraw a fixed percentage of your portfolio annually. The amount you withdraw will vary as the value of your portfolio rises or falls.
This withdrawal approach naturally adjusts your withdrawals in response to market fluctuations. However, if your withdrawal percentage is high, you risk being out of money very soon. Also, since your retirement income changes from year to year, you may find it difficult to make financial plans.
Systematic withdrawal strategy
In this withdrawal strategy, you keep the principal intact and only withdraw dividends or interest generated by the investments in your portfolio.
With this approach, you cannot run out of money in your retirement account. Unfortunately, your nest egg needs to be big enough to provide enough income to last for as long as you live. Since the income varies every year, depending on market performance, you might find it difficult to create a financial plan; moreover, if your investments don’t grow with the rise of inflation, your buying power can drop drastically.
Retirement Withdrawal Strategies At a Glance
Retirement Withdrawal Strategy
How It Works
|The 4% rule withdrawal strategy||Withdraw 4% of your account balance in the first year of retirement, then adjust the amount upward after a few years to keep pace with inflation.|
|Bucket withdrawal strategy||Distribute the retirement assets into different accounts: some in a savings account, some in fixed-income securities, and some in equities. Draw money from the savings account and refill it with money from the other two accounts when they are performing well.|
|Fixed-dollar withdrawal strategy||Withdraw the same amount each year|
|Fixed-percentage withdrawal strategy||Withdraw the same percentage of your account balance each year|
|Systematic withdrawal strategy||Withdraw only income from your investments (interest and dividends), keeping the principal invested.|
The right retirement withdrawal strategy for you will depend on how much retirement savings you have, how worried are you about outliving your money, and whether you’re considering extreme early retirement. These withdrawal strategies may not be a one-size-fits-all solution. You can consider a mix and match to come up with an optimal retirement withdrawal strategy unique for your circumstances.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.