How to Begin Withdrawing From Your 401(k) or IRA After Retirement

Meeting a financial planner
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As you near retirement, you need to start thinking about the transition from living on your employment income to living on your savings. Beyond the emotional issues that can make you afraid to break open that piggy bank, you'll have many practical issues to face as well.

How much should you withdraw initially? What rate of withdrawal over time will ensure that you won't outlive your savings but will still be substantial enough that you can enjoy life?

Remember that your retirement savings accounts don't grind to a halt when you begin retirement. That money still has a chance to grow, even as you withdraw money to help pay for your living expenses. But the rate at which it will grow naturally declines as you make withdrawals because you'll have less invested. Balancing the withdrawal rate with the growth rate is part of the science of investing for income.

The 4 Percent Rule

Many financial advisers recommend the "4 percent rule" when evaluating how much you can take out of your retirement accounts without fear of outliving your savings. The idea is that you should be able to withdraw 4 percent annually and maintain financial security.

A famous study by Bill Bengen in the 1990s showed that a 4 percent withdrawal rate over 30 years had the best chance for success even as it adjusted for inflation. But several variables can make this rule of thumb either too conservative or too risky, and you might not be able to live on 4 percent a year unless your account has a significantly large balance.

Your Personal Situation

Some say that a 7 percent withdrawal rate is relatively safe, while others insist you should set a limit of 2 percent, particularly in the first year or so. Like many financial solutions, the answer depends on your own unique circumstances: your life expectancy, the performance of your investments, how much you need to meet expenses, your spouse, Social Security, or a second job you might decide to take on.

You can run your own retirement calculations to get a sense of what you'll need and what you might be able to count on. There are many useful retirement calculators on the web, but it's a good idea to get advice from an unbiased financial professional as you near retirement.

Emphasizing Income Over Growth

Bonds, stocks, real estate, and other types of assets pay either fixed or variable income. It's a common strategy to allocate more of your portfolio to fixed-income investments as you near retirement. Fixed income can be a safer bet, and it can also help shift your portfolio to a place where it's focused on producing steady income rather than a large return on investment.

Income investments generate dividends or interest. Ideally, you could use that income to cover living expenses without touching the principal or the initial investment amount.

The problem is that it's hard to get any yield on your investments without taking on a lot of risk these days. And the payoff isn't huge even if you are willing to accept some risk.

A Laddering Strategy

Many investors who seek a slight yield boost will try a laddering strategy with certificates of deposit (CDs) or short and medium-term bonds. A ladder strategy tries to blend the liquidity of short-term investments with the higher yields offered by longer-term investments. Instead of buying one five-year bond that pays 3 percent, you would buy five bonds that mature at different rates over the next five years. The shorter-term investments will pay less, and the longer-term ones will pay more.

Spreading your money across a variety of maturities can help you get a decent return without giving up your liquidity. You have a way to get your hands on the cash should you need it, and you can reinvest with bonds or CDs maturing each year. Hopefully, rates will be better by then.

Choosing the First Account

Another consideration is which account to draw from first. How to do this in the most tax-efficient way also depends on your individual situation. You can start withdrawing funds from a retirement account without penalty after age 59 1/2, but you don't have to start taking required minimum distributions (RMDs) from tax-deferred retirement accounts until age 70 1/2.

A Roth IRA works differently. There are no RMDs, so you can let that money grow tax-free for as long as you like.

You might want to strategize your withdrawals to reduce your annual tax bill in some cases. Withdrawals from a Roth IRA are tax-free in retirement, so you may want to periodically take some money from that account rather than another one.

Talk to a financial adviser or your plan administrator to determine the best strategy for you if you have a combination of investment accounts. You might also consider converting to a Roth IRA before or during retirement. Again, a financial professional can outline whether this makes sense depending on your needs and goals.

Considering Your Beneficiaries

If you don't outlive your funds or you're not able to withdraw all your retirement funds before you die, the money will be passed on to the beneficiaries you named when you opened the accounts. It's a good idea to check in with your beneficiaries periodically, or perhaps after a life change such as a marriage, the birth of a child, or divorce because they'll pay income tax on these windfalls.