As you near retirement, you need to think about the transition from living off your employment income to your savings. Beyond the emotional issues that can make you afraid to break open that piggy bank, you'll have to figure out how best to withdraw money from your 401(k) or other retirement accounts after retirement.
Specifically, you'll need to decide how much money you should withdraw from your account initially and a rate of withdrawal over time that will ensure you won't outlive your savings and can enjoy retirement living. There are several withdrawal considerations you must make.
Continued Growth vs. Inflation
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 it from your 401(k) or other accounts after retirement 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.
You also need to take inflation into account. This increase in the cost of things we purchase typically comes out to about 2% to 3% a year, and it can significantly affect your retirement money's purchasing power.
The 4% Rule
Many financial advisers recommend the 4% rule when evaluating how much money you can withdraw from your 401(k) or other retirement accounts without fear of outliving your savings. Using this rule, you take out 4% of your retirement savings the first year and base subsequent withdrawals on the rate of inflation. The idea is that you should be able to withdraw somewhere in the vicinity of 4% annually and maintain financial security for 30 years.
For example, if you start your retirement with $1 million in savings, you would take out 4%, or $40,000, in the first year. If inflation rises 2%, you would take out an additional 2% of that initial amount, or $800 ($40,000 x 0.02), for a second-year withdrawal of $40,800.
The 4% rule is the result of a famous study by financial adviser Bill Bengen, which showed that a 4% withdrawal rate adjusted for inflation was safe over a 30-year period.
Caveats to the 4% Rule
Several variables can make this rule of thumb either too conservative or too risky, and you might not be able to live on 4%-ish a year unless your account has a significantly large balance.
The first caveat you should consider when thinking about applying the 4% rule to your personal situation is that it calls for putting 50% each in stocks and bonds. You may not be comfortable putting that much of your retirement assets in equities, and you may want to keep at least a portion of your nest egg in cash or a money market fund.
You also might not expect to live for 30 years after retirement, either because you retired later than most people do or for some health-related reason. And you may not feel you need the almost 100% confidence level Bengen was seeking in his rule; a confidence level of 75% to 90% that you won't run out of money might be acceptable to you and may afford a more flexible withdrawal rate.
Your own unique financial circumstances must also be taken into account when deciding how much money you can withdraw from your 401(k) or other accounts after retirement. You may be receiving a pension, have a younger spouse who will continue to work, or plan on taking a part-time job during retirement. You and your spouse's Social Security payments and the amounts of monthly expenses you anticipate based on your lifestyle wants and everyday needs are also important factors.
Online retirement calculators can help you with your withdrawal decisions, but you might also want to consult with a financial planner who was recommended by someone you trust.
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, guaranteed 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 can be hard to get any yield on your investments without taking on 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%, you might buy five bonds that mature at different rates over the next five years. The shorter-term investments would pay less, and the longer-term ones would 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.
The First Account
Another consideration is which retirement account to starting withdrawing money 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 401(k) or IRA without penalty after age 59.5, but you don't have to start taking required minimum distributions (RMDs) from tax-deferred retirement accounts until age 72 (70.5 if you reached age 70.5 before Jan. 1, 2020).
A Roth IRA works differently. There are no RMDs during the account owners' life, so you can let that money grow tax-free for as long as you like.
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 401(k) plan administrator to determine the best strategy for you if you have a combination of investment accounts. You might also consider converting a traditional IRA to a Roth IRA before or during retirement. Again, a financial professional can outline whether this makes sense depending on your needs and goals.
If you don't outlive your funds, your 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 may have to pay income tax on these windfalls and will have to follow rules on withdrawal amounts.