Retirement: Withdrawal Rates, Longevity and RMD Taxes
There are two main concerns for retirees when drawing down assets in retirement. The first is longevity risk which is whether they will have enough money to last their lifetime. The second is minimizing tax obligations to keep more of their retirement savings. Retirees need to consider a few key decisions to help navigate these two concerns. These include deciding on a safe withdrawal rate of savings in retirement, when to apply for Social Security Retirement Benefits and how to mitigate taxes from Required Minimum Distributions (RMDs) which currently begin at age 72.
Safe Withdrawal Rates Overview
One of the lightning rod topics of personal finance is recommending a safe withdrawal rate for retirees. The withdrawal rate is the amount of money that retirees will withdraw from their savings each year to live on. Most retirees use an annual withdrawal rate between 3-4% of their total portfolio. At 3.5% a person with $1 million in retirement assets would withdraw $35,000 in their first year of retirement. The amount would increase each year based on inflation.
Safe Withdrawal Rates Can Be Controversial
The reason determining a safe withdrawal rate can be controversial is the rate depends heavily on the risk tolerance of the retiree, their age at retirement, their life expectancy and the type of assets they own. A withdrawal rate that is perfect for one retiree may be too high or too low for another retiree. Withdrawal rates may also be revised based on future inflation rates and annual returns on retirement portfolios.
For example, a person retiring at age 70 with a family history of early mortality will have a very different withdrawal rate than a person in excellent health who retires in their 50s and expects to live into their 90s. In addition, a person who has 70% of their retirement income needs covered by an annuity or pension has more security than a retiree with 70% of their retirement savings in stocks. There are more details on determining a safe withdrawal rate here and also strategies for strengthening an annual withdrawal rate explained here.
Life Expectancy and Retirement Planning
When planning for retirement it helps to start by looking at life expectancy rates. In North America, life expectancy for men is 79 years of age and 81 years of age for women. This means that most people retiring now at age 60 will need to rely on their retirement savings for about 25 years or less. However, life expectancy is rising and the census bureau reports that 4.7% of the U.S. population age 65 or over is in their 90s, but this number could rise to 10% by 2050. Younger workers will need to calculate these trends in their retirement planning and current retirees who have a family history of higher longevity will want to boost their savings to account for these extra years of retirement.
Accessing Retirement Accounts at Age 59.5
Most future retirees will have the bulk of their retirement savings in tax deferred accounts like the 401k and Individual Retirement Accounts. These funds are not accessible without paying a 10% penalty until age 59.5. Therefore, most retirees will not tap these funds until they are nearly age 60 or older. People looking to retire earlier than age 60 will need savings that are accessible at a younger age, such as rental properties or traditional brokerage accounts.
A future retiree may want to begin withdrawing some of the funds in their tax deferred retirement accounts even if they do not need it. This money can be re-invested in a non tax deferred account if it is not needed to pay living expenses. Earlier withdrawals will help to avoid RMDs, which are explained in detail below. In addition, see Taxes on 401k Withdrawals in Retirement.
When to Apply for Social Security Retirement Benefits
Most current workers will reach their Full Retirement Age for Social Security Retirement Benefits at age 67. Benefits can begin as early as age 62 but applying early will reduce monthly benefits by 30%. Similarly, monthly benefits can be delayed until age 70. Benefits will be 8% higher for each year after the age of 67 that benefits are delayed until age 70. There is no benefit for delaying benefits until after age 70. For example, if Jess waits until age 70 to apply for benefits they will be 24% higher than they would have been at age 67.
There is no right answer for when to apply for Social Security Retirement Benefits. However, if a person has not sufficiently saved for retirement, working longer and delaying benefits until age 70 is one of the best strategies for strengthening retirement income. If a shorter life expectancy is a concern, a retiree may want to apply for benefits earlier. If a retiree does not expect to live very long they may want to enjoy this money as soon as possible.
Taxes: Required Minimum Distributions
As retirees consider a safe withdrawal rate they also need to consider the impact of Required Minimum Distributions (RMDs). The Internal Revenue Service (IRS) requires retirees age 72 or older to take a minimum distribution from their taxable retirement accounts before December 31 each year. Taxable retirement accounts include 401k and traditional Individual Retirement Accounts (IRA). RMD does not apply to Roth 401k, Roth IRA, or traditional brokerage accounts. If a retiree fails to take the required distribution the IRS imposes a 50% tax penalty on the amount that was not taken for the year. The RMD mandated rate may also be higher than a retiree's preferred safe withdrawal rate. This is why it can be advantageous to take some distributions from these accounts well before the age of 72.
For example, Noah is age 80 and has $1 million in a taxable retirement account so he must take a distribution of $53,476 by December 31. If Noah takes less than this amount the IRS imposes a tax on the amount he did not take. Also this RMD rate is 5.4% which might be much higher than Noah's preferred withdrawal rate of 4%. He can still save any portion of this distribution that he does not spend in the year. If he reinvests this amount in a traditional brokerage account it will no longer be subject to RMD provisions. Alternatively he could have taken distributions once he turned 59.5 to lower the amount of his retirement savings that are subject to RMDs.
The reasoning behind RMDs is that you did not pay taxes on this money when it was earned, so the IRS wants to tax it before it passes to your heirs. There is proposed legislation to raise the age when RMDs are required but the House and Senate have not finalized these provisions. The Senate proposal would also waive RMDs for individuals with less than $100,000 in aggregate retirement savings, as well as reduce the 50% penalty for failing to take RMDs to 25%. The proposals could raise the age for RMDs to 75 beginning in 2032 but these rules have yet to pass.