A successful financial strategy starts with developing a retirement income roadmap for the years ahead. This roadmap has several different moving parts and may seem overwhelming at first. From creating a realistic retirement budget to deciding how and when you’ll take withdrawals from various accounts, there’s a lot to think about.
Create a Budget
The first part of creating your income roadmap starts with deciding how much you’ll need to live in retirement. Whatever your retirement dreams may be, in order to reach them, it’s crucial to set clear income goals and a retirement budget. The figure you come up with will provide a goal to work toward and help you decide how much you’ll need to save now in order to live comfortably when you stop working. (For related reading, see: 3 Costly Retirement Account Mistakes to Avoid.)
A good way to start thinking about your income goals is to pretend as if you are retiring tomorrow. How much would your monthly check need to be? You could state your goal as either a sum of money or as a portion of your salary. To come up with this figure, start with your basic monthly living expenses including food, shelter, utilities, clothing, taxes, insurance, transportation. Also be sure to factor in costs of any family members who depend on you, as well as the rate of inflation, which has averaged 2.5% over the past 20 years.
Some of your expenses may decrease in retirement if your mortgage or other debts are paid off. But keep in mind with the extra time on your hands, you’ll probably want to have more income for travel and leisure activities. Try to set a realistic budget according to your discretionary desires that will allow you to enjoy your well-earned freedom. Also remember that when you hit your 70s and beyond, you will likely be spending more on healthcare, which can have a substantial impact on your retirement savings. Be sure to factor in a cushion of funds that will cover such expenses.
Use Deferred Income Streams First
After you’ve set a retirement budget, it’s time to decide to decide the order in which you’ll use certain income streams to sustain you through your golden years. I recommend tapping into deferred income sources first. These include Social Security funds and monthly pensions. Once you reach full retirement age—age 66 for those born between 1943 and 1954 and age 67 for those born in 1960 or later—you’ll automatically receive checks from these sources. Since you’ll already be paying taxes on this income, there’s no need to dip into other retirement accounts unless it doesn’t cover all your expenses. (For related reading, see: 5 Financial Planning Decisions You Won’t Regret.)
Be Strategic with Other Account Withdrawals
For many retirees, living on deferred income simply isn’t sufficient, in which case you should develop a plan for how you’ll supplement those funds with withdrawals from other accounts. Try to abide by the following methods when deciding which funds to access first and how much to withdraw.
The 4% rule.It’s a good idea to withdraw a maximum of 4% annually from a particular retirement account. This percentage will hopefully provide a steady stream of funds to cover expenses in retirement. It also allows funds to be withdrawn for a number of years from that account. The 4% rate is considered a safe rate, with the withdrawals consisting primarily of interest and dividends. The 4% rule stems from a 1994 study by financial planner William Bengen. After testing a variety of withdrawal rates using historical rates of return, Bengen found that 4% was the highest rate that held up over a period of at least 30 years. You can carry this rule out by annually withdrawing 4% of the value of all your investments that are designated for retirement funds.
To reflect the impact of inflation, however, you would increase the dollar amount of your first withdrawal in the following years. Some experts argue that an initial withdrawal rate closer to 3% may be more appropriate for those that want their retirement investments to sustain them for at least three decades. If your budget calls for less than 4% annually, then that’s obviously a good thing. But if it calls for more than 4% of your retirement funds, it’s time to go back and trim your budget. In the end, it’s a good idea to work with a trusted financial professional to decide an amount that is right for you.
Tap into taxable accounts first.If you’re withdrawing funds for retirement before you reach age 70.5 and have to take required minimum distributions (RMDs), you should consider withdrawing money from taxable accounts first. These include investments like stocks, bonds, mutual funds and real estate. You already have to pay taxes on these every year, so why not go ahead and take the money? Tapping into these sources first will also give other accounts, such as IRAs and 401(k)s, more time to grow in a tax-free manner. As a general rule, it’s good to delay tax payments for as long as possible.
A stock that sells with a capital gain from a taxable account incurs a capital gains tax. It’s usually taxed at a lower rate than ordinary income tax rate. On the flip side, the same appreciated stock withdrawn from a traditional IRA may be hit with a steeper tax rate. This is because all withdrawals from the IRA are taxed as ordinary income.
Access tax-free accounts next.Tax-free accounts include tax-free municipal bonds and Roth IRAs. Because you’ve already paid taxes on the money in a Roth IRA, you can receive the full value of the account, including investment earnings, without having to pay taxes when you withdraw the money. The two stipulations are that the Roth has been open for at least five years and you’re age 59.5 or older. They also have the added advantage of not having RMDs, so there is no particular age in which you’re required to take withdrawals.
When you leave such contributions untouched for as long as possible, they can grow and compound without any tax implications. They can also be easily passed on to heirs.
Withdraw from tax-deferred accounts last.Tax-deferred assets include traditional IRAs, 401(k)s, and annuities. These should be accessed once you’ve used up most of your taxable retirement money, as well as tax-free accounts. If you are past age 59.5, you’ll avoid any early withdrawal penalty when you access these accounts. Remember, as previously stated, the withdrawals themselves from these accounts typically are taxed as ordinary income. By waiting to withdraw money from these accounts, you receive more tax-deferred growth.
You may want to delay withdrawals from annuities in particular as long as you can, because the older you are when you start your payouts, the greater your payout amount will be, although it will also be taxable. (For related reading, see: How to Create an Effective Budget.)
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.