If you want financial security in retirement, it’s important to have a well-planned withdrawal strategy, also known as a decumulation strategy. That’s because choosing the best way to access and spend your retirement savings will help you get the most out of it. By thinking ahead, you may avoid paying unnecessary taxes and running out of money.
There are many methods for withdrawing retirement savings, and there isn’t a single approach that’s right for everyone. In fact, most financial professionals agree it’s a good idea to use a combination of them.
Learn about 7 commonly used strategies below and consider which may fit your needs best.
1. Use the 4% rule
Created by a financial professional in the 1990s, the goal of this strategy is make sure your money will last for 30 years. It calls for withdrawing an amount that equals 4% of your entire retirement portfolio during the first year of retirement and then adjusting that withdrawal amount for inflation each year thereafter.
However, the 4% rule doesn’t work for everyone or through all market conditions. In fact, some experts consider it outdated. So, if you decide to use it, think of it as a guideline rather than a rule. You may want to adjust the percentage based on your circumstances and goals.
2. Make tax-conscious withdrawals
When you make withdrawals from your accounts in a certain order, you can minimize taxes on what you take out and leave the remaining funds invested so they have time to grow. Some experts suggest that you pull from taxable accounts first, tax-deferred accounts second and tax-free accounts last.
However, you’ll need to consider your income and tax situation to decide which order will work best for you. As your finances change year to year, you may also decide to adjust the order. For example, if you land in a higher-than-usual tax bracket one year, withdrawing from a tax-exempt account, such as a Roth IRA, may help you avoid higher taxes. Consulting with a tax advisor can help you sort through your options and determine the best approach.
3. Make fixed-amount withdrawals
If having steady cash flow sounds appealing, consider taking systematic withdrawals from your retirement savings. That means you’d choose a set payment amount to withdraw periodically, such as every month, quarter or year.
While this might be a good strategy to generate your retirement income, it doesn’t account for investment performance. If your investments don’t grow as expected, your overall account value might not be enough for you to make regular withdrawals at the same level throughout retirement.
4. Withdraw earnings, not principal
To avoid spending down their principal, some retirees choose to withdraw only the earnings from their investments each year and leave the principal untouched. This strategy can be useful if your principal is large enough to create a liveable income from interest and dividends.
However, it could result in an unpredictable income, as your investment performance and dividends fluctuate. That could especially affect your income during volatile markets.
5. Adopt a total return strategy
This strategy calls for looking at each asset, such as a stock or bond, based on its percentage change in value (or "total return") over a specific time period. This total return includes income the asset generates, such as dividends and interest, and increases in value, such as a rising stock price.
Essentially, you'd choose investments that could create cash flow from interest and dividends or capital gains (profits from selling them). Your payouts could come from any of these sources. If you don't feel comfortable selling assets, though, you may feel safer using a strategy focused on interest and dividend income instead.
6. Tap your savings by bucket
With this strategy, you divide your retirement investments into three buckets:
- Immediate (short-term)
The idea is to withdraw your income from the first bucket, which is continually replenished with earnings from the others.
Withdrawing your funds this way can provide peace of mind since it reduces the chance that you’ll run out of money. It can also prevent you from needing to sell investments during a market downturn for cash. Over- or underestimating how much to put in each bucket, though, can make this strategy less effective.
Cash or bond funds
For money needed in the next 3 years, these low-risk assets can help protect against losses.
A mix of stocks & bonds
For money needed in the next 3 to 10 years, these moderate-risk investments can seek moderate growth.
For money not needed for 10+ years, these higher-risk investments seek to maximize growth.
7. Effective use of required minimum distributions
Many retirees rely on required minimum distributions (RMDs) to signal when they should withdraw money from their retirement accounts. RMDs are minimum amounts that an individual must take out of their tax-deferred retirement accounts annually once they reach age 73 if they turn 72 after 2022. That age bumps up to 75 for those who turn 74 after 2032.
To calculate your RMDs, divide the amount of money you had in an account at the end of the past year by the IRS's "life expectancy factor" that corresponds to your age. To find your factor, consult the life expectancy tables in IRS Publication 590-B. Repeat the process for all your retirement accounts, because you'll need the RMD for each one.
By taking out the required amount during the year, you can avoid being subject to high tax penalties.