For decades, you’ve saved and invested diligently to fund the retirement lifestyle you’ve always dreamed of. But did you know that how you withdraw your money in retirement greatly impacts how far those savings can stretch? Some people find that developing a tax-efficient withdrawal strategy is just as (if not more) complex than building up those savings in the first place.
All of this isn’t to deter you from spending your money in retirement. Just the opposite! This is the time to reap the rewards of your hard work, and we want you to get the most out of your savings. To do that, you must create and execute a sustainable withdrawal strategy — which we can help you with.
Let’s look at a sustainable withdrawal strategy and what those in or near retirement should consider when building one.
Understanding the 4% Rule
The 4% rule is commonly used for determining how much retirees can safely withdraw from their portfolio each year.
The 4% rule was established by financial advisor William Bengen in 1994. Before Bengen’s research, the consensus was that retirees would be safe withdrawing 5% each year. However, Bengen analyzed historical stock and bond market return data between 1926 and 1976 (a 50-year period) to determine if this was true.
He concluded that under any economic climate (through periods of both growth and decline), retirees would be safe withdrawing 4%, as opposed to the previously assumed 5%, from their portfolio each year (adjusted for inflation).
It’s important to note that the 4% rule was created with a few assumptions. First, it assumed that retirement would last 30 years. And second, investors would maintain an investment portfolio of 60% equities/40% bonds.
These rules, of course, may not be accurate for everyone, and they don’t account for significant market fluctuations or other factors that impact your portfolio — like prolonged volatility, poor bond market performance, or an investor’s tax liability.
Concerns About the 4% Rule
The critical thing to remember is that this is a rule of thumb, but it may not reflect what’s best for your unique situation. It’s more of an “in a perfect world” scenario, which, as we’ve seen in recent years, doesn’t always reflect reality.
Just consider the historically high inflation of 2022 and 2023 and the subsequent rise in interest rates. Those economic conditions were undoubtedly out of the ordinary, and many retirees (at least those who wanted to protect the longevity of their portfolio) found it necessary to adjust their withdrawal rates accordingly.
Rather than rely on a generally accepted rule for withdrawing, use the 4% rule as a good starting point — and tweak it from there to fit your needs. Working with your financial professional, you can create a custom withdrawal rate that reflects the current market conditions, your estimated timeline, and your anticipated income needs in retirement.
The Importance of Making Tax-Efficient Withdrawals
The tax status of your portfolio can impact how much you withdraw each year and from which “bucket” of money.
Your portfolio is made up of a mix of tax-free income (like Roth accounts), taxable income (from a brokerage account), and tax-deferred income (from a 401(k) or traditional IRA). Here are a few strategies for making tax-efficient withdrawals in retirement when utilizing different types of income.
Plan for RMDs
Tax-deferred retirement savings accounts like 401(k)s and traditional IRAs are subject to required minimum distributions (RMDs). Beginning when you turn 73, you will be required to withdraw from these accounts each year. The IRS mandates these withdrawals because, unlike Roth accounts, they have not yet collected taxes on the contributions (or growth) — and they don’t want retirees holding onto the funds indefinitely without paying taxes.
The tricky part about RMDs is that they add to your taxable income for the year, whether you want to take them or not. You and your advisor should discuss ways to strategically incorporate RMDs into your retirement income strategy, as there may be ways to reduce their impact on your overall tax liability.
For example, you can donate some of your RMDs directly to charity and deduct the amount from your taxable income. Or, you can do a Roth conversion, which involves rolling the funds over to a Roth account and paying the tax liability immediately. You may also want to withdraw from your 401(k) or IRA early. This would reduce the overall size of the accounts (which impacts how much you’re required to withdraw each year).
It’s also worth noting that neglecting to take your RMDs can lead to hefty tax penalties from the IRS. Before passing the SECURE 2.0 Act in 2022, failing to withdraw your RMDs would result in a staggering 50% tax penalty on any amount not withdrawn. However, the penalty has dropped to 25% (which is still a significant amount). If you can remedy the situation within two years, the penalty drops to 10%.1
Keep Your Tax Bracket in Mind
You’re essentially creating your paycheck in retirement, which gives you more freedom to control your tax bracket than you may have had during your working years.
If you’re teetering toward the top of your tax bracket, perhaps you want to pull from after-tax accounts (like your Roth). The key is to keep a close eye on your tax bracket in the first place. Otherwise, you may increase your tax liability unnecessarily.
Hold on to Investments for Over a Year
Anytime you purchase a security or investment and sell it at a profit, you may be liable for paying capital gains tax on the profit (called capital gain). So, while you’ll likely want to pull from your brokerage account to help cover your expenses in retirement, be mindful of how long you’ve held onto an investment before selling it off.
If you sell a security you’ve had for less than a year, the gains will be subject to short-term capital gains tax. On the other hand, securities held onto for a year or longer are subject to long-term capital gains tax — which is a much more favorable tax treatment.
Short-term capital gains tax is the same as the rate you’d pay on your ordinary income, meaning it can go up as high as 37%. Capital gains tax will also vary based on income, but it’s capped at 20%. Some people will pay as little as 0% on their long-term capital gains.
Balancing Growth and Income
Generally speaking, the closer you get to retirement, the more conservative your portfolio becomes. This is to help protect your retirement income from market volatility and fluctuations while allowing it to grow.
Your asset allocation and investment strategy will likely evolve throughout your retirement, just as during other phases or transitions in your life. But now more than ever, working with your advisor to find the right balance between preserving your capital and generating enough income to sustain a comfortable lifestyle is essential.
Nobody wants to have to go back to work well into retirement because the markets took a downturn. By adjusting your portfolio to account for market fluctuations, you and your advisor should be able to prevent this.
Combatting Longevity Risk
Longevity risk refers to the risk of outliving your savings. More and more people are living longer and retiring earlier. If you’re concerned that you may outlast your savings, you and your advisor can discuss longevity-focused financial tools, such as annuities.
It may also be helpful to gradually make the transition to retirement by picking up a part-time job, taking on a consultant role, or offering contract work. This can lessen the emotional impact of retiring and delay the need to withdraw from your savings accounts.
Other Considerations to Keep in Mind
As you develop your withdrawal strategy, other essential factors must be considered. Healthcare costs are statistically going to rise as you age, so having an emergency fund and proper insurance coverage will be necessary. In addition, you’ll want to think about how your withdrawal decisions impact your estate plan.
If you have questions about your retirement income plan, or you’re looking for ways to make more tax-efficient withdrawals, don’t hesitate to reach out to us anytime. We’d be happy to review your current saving and spending strategy and help you develop a tailored plan with sustainability and longevity in mind.
Partners in Financial Planning provides tax-focused, comprehensive, fee-only financial planning and investment management services. With locations in Salem, Virginia and Charleston, South Carolina, our team is well-equipped to serve clients both locally and nationally with over 100 years of combined experience and knowledge in financial services.
To learn more, visit https://partnersinfinancialplanning.com