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  • Nate Carter

Withdrawing Funds in Retirement

Investors often have a great plan to save for retirement, but neglect to consider how they will drawdown these assets in retirement. Some retirees also find the transition from asset accumulation to distribution to be a bit scary. This is understandable as these assets offer security and peace of mind. A successful retirement requires a proper distribution plan. The steps below will help you design a sustainable and tax efficient plan for drawing down your assets.


Put Your Portfolio on Autopilot


A common mistake of retirees in the distribution stage is reacting to market volatility by changing the holdings in their portfolios. This leads to selling positions in an effort to time the market. The only way to avoid these mistakes is to take the emotion out of investing by putting your portfolio on autopilot. This requires following one strategy in perpetuity regardless of market volitivity.


Hold a Broad Index of Stocks and Bonds


To achieve this autopilot goal and provide a sustainable retirement, experts recommend a portfolio of 60% stocks and 40% bonds. The stocks held should be a low cost broad index fund like the S&P500. Similarly, the bonds held should also be in a low cost broad index fund. This portfolio mix protects you from running out of money over the next 30 to 40 years and provides the annual appreciation needed to keep up with inflation. It is prudent to ignore daily news reports about market volatility, because changing your strategy or trying to time the market will lead to worse returns in the long run.


Rebalance on Your Birthday


In retirement the only change you will make to a portfolio is to rebalance it annually to return to the mix of 60% stocks and 40% bonds. Over time failing to rebalance will cause a portfolio to become too heavily weighted in either stocks or bonds. It is best to rebalance on the same day each year, such as on your birthday, so you are consistent and don't forget.


Don't Hold Your Company Stock


Some retirees skip a broad portfolio mix of stocks and bonds and instead hold the bulk of their retirement fund in their former employer's stock. Such a lack of diversification can lead to catastrophic results. Companies that were once business stalwarts such as Enron, WorldCom, Neiman Marcus, Lord & Taylor, Circuit City, General Motors, Chrysler, Sears, J.C. Penny, Toys R Us, Lehman Brothers and Washington Mutual all went bankrupt. And this is just a few of the businesses that have failed over the years. When these companies closed they wiped out billions of dollars of stock value held by retirees. It is foolish to take such an unnecessary risks in retirement.


Automate Your Distributions


Experts suggest a 4% withdrawal rate on your assets, plus an increase for the annual inflation rate. For example, if you have a portfolio of $400,000 you would withdraw $16,000 this year. If inflation is 2% for the year you would withdraw $16,320 next year if the account balance remained at $400,000. If the market performs well and your account grows to $450,000 your 4% withdrawal would be $18,000 for the year. Similarly you will see a smaller distribution in the years where your account value has declined. You can take these distributions in a lump sum at the end of the year, or quarterly or monthly. The choice is yours. What is important is to automate these withdrawals at 4% of the total portfolio for the year.


Avoid the Big Withdrawal Mistake


A common mistake of new retirees is taking a major withdrawal at the start of retirement to purchase a depreciating asset such as a boat, RV, or a luxury car. This move robs you of all the future income that would have been generated from this money. Buying a $50,000 boat deprives you of at least $2,000 in annual income for the rest of your life. There are strategies to generate the necessary income to make these types of purchases prior to retirement explained in Become Loaded for Life.


Tax Efficient Withdrawals


The next step is to make your withdrawals tax efficient, so your money goes further in retirement. To reduce taxes mix your withdrawals from taxable and non taxable accounts. Taxable retirement accounts include the 401k, traditional IRA, 403b or Thrift Savings Plan (Federal workers). Non-taxable retirement accounts include the Roth IRA or Roth401k. With non-taxable accounts, the money contributed was already taxed so the withdrawals in retirement are tax free.


For example, lets say you have $500,000 saved for retirement and this includes $400,000 in a 401k and $100,000 in a Roth IRA. When following the 4% rule your total distribution is $20,000 for the year. But, by withdrawing $16,000 from your 401k and $4,000 from your Roth IRA you will lower your income tax for the year. You will only pay tax on the $16,000 from your 401k. The $4,000 from your Roth IRA will be tax free. Blending these withdrawals between the two accounts keeps you in a lower marginal tax bracket and reduces your income tax for the year. Especially, if you have other sources of income in retirement including Social Security Retirement Benefits.


Beware of Required Minimum Distributions


The last thing to consider for your withdrawal plan is the Internal Revenue Service (IRS) requirement for Required Minimum Distributions (RMDs). The IRS requires retirees age 72 or older to take a distribution from their taxable retirement accounts before December 31 each year. If you fail to take the required distribution Uncle Sam imposes a 50% tax penalty on the amount you neglected to take for the year.


For example, at age 76 if you have $1 million in a taxable retirement account you must take a distribution of $45,454 by December 31. If you only take $35,454 the IRS imposes a tax of $5,000 on the $10,000 you did not take. Also each year the RMD amount increases as you age, see the IRS's RMD formula online. The reasoning behind RMDs is that you did not pay taxes on this money when it was earned initially, so the IRS wants to tax it before is passes to your heirs.


There is proposed legislation to raise the start of RMDs to age 75 beginning in 2032 but these rules have yet to pass. The reason retirees are concerned about RMDs is that people are living longer, and they prefer to let their money grow before subjecting it to tax. However, if you are required to take RMDs and you do not need all of this money to live on, you can immediately reinvest the proceeds in a traditional brokerage account. Following the 60% stocks and 40% bonds portfolio mix discussed above will keep your money growing in retirement. And the funds in traditional brokerage accounts are not subject to RMDs so you will not be forced to take future distributions.


If you want to learn more about steps to take before you retire see Turning 50: Ten Factors to Consider part 1 and part 2.


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