managing it - continued
PLAN FOR A FLEXIBLE DRAWDOWN
Learning how to draw down your assets and how to utilize tax diversification strategies can seem overwhelming at first. If that is the case, you may opt to take advantage of automatic investing strategies and vehicles such as retirement funds, which make age-appropriate retirement investment decisions for you. Even so, sitting down once a year to consider the following core strategies can help ensure that you are on track to achieve your goals and prepared to meet life's challenges.
Start with the 4% rule.
Plan to withdraw 4% of savings during the first year of retirement, then increase that dollar amount for inflation each year. For example, if you have $500,000 in savings at retirement, you should plan to withdraw $20,000 in your first year of retirement. The following year you would withdraw $20,000 plus the amount that equals the rate of inflation (3% for example), and in each subsequent year you would repeat that increase for inflation. Says Fahlund, "This approach typically enables you to have a good chance of not running out of money while supporting a consistent, inflation-adjusted lifestyle throughout retirement. It's important to review your situation annually, however, to ensure you stay on track."
Adjust withdrawals as your life evolves.
Following a bear market, you may decide to withdraw less to reduce the risk of prematurely depleting your savings. For instance, you might elect to forgo an inflation adjustment for a year or more until the market begins to rebound, or simply reduce the dollar value of your withdrawals temporarily, while being sure to take any required minimum distributions (RMDs) from your retirement accounts. On the other hand, if the market performs especially well for three or more years, you could consider increasing your withdrawals somewhat more than you anticipated.
Use withdrawals to reallocate your portfolio.
It is important to adjust your overall asset allocation to a targeted mix of asset classes annually. As you near retirement, your allocation to stocks should gradually decline. "You should hold close to 60% of your assets in stocks as you approach retirement," says Fahlund. "Then, as you age, you want to gradually reduce that figure down to 20% once you're 30 years into retirement." One technique for rebalancing your portfolio in retirement involves targeting your withdrawals to the asset class you need to reduce. For example, generating cash by selling stock holdings would gradually reduce your exposure to stocks and increase the percentage of assets held in more stable investments, such as bonds. If completing this process each year does not appeal to you, consider investing in a retirement-date fund, where all of the rebalancing and reallocation is done by the manager of the fund. Keep in mind that the principal value of target-date funds is not guaranteed at any time, including at or after the target date, which is the approximate date when investors plan to retire. These funds typically invest in a broad range of underlying mutual funds that include stocks, bonds, and short-term investments and are subject to the risks of different areas of the market. In addition, the objectives of target-date funds typically change over time to become more conservative.
Create financial flexibility with tax diversification
Holding account types that are taxed in different ways can increase the control you have over your income taxes in a given year. "We have no idea how tax rates or our personal situations will change in the coming years," says Fahlund. "So you need to manage your retirement accounts to have maximum control over your taxable income throughout retirement." To understand how this strategy can provide greater flexibility, consider the following differences between traditional retirement, Roth IRA, and taxable accounts:
- Withdrawals from Traditional IRAs and 401(k) plans are taxed as ordinary income as long as your contributions were deductible. If you made nondeductible contributions, a fraction of your withdrawals is not taxed.
- Withdrawals of earnings from Roth IRAs are not taxed as long as you have held the account for at least five years and have reached age 59½. However, you can withdraw your contributions, which come out of the account first, at any time without penalty.
- Withdrawals from taxable accounts may trigger taxes when you sell securities.
You likely have the majority of your retirement assets in Traditional IRA and 401(k) accounts. Balancing your withdrawals from those accounts with withdrawals from taxable accounts or Roth IRAs may help you manage your annual tax bill. Consider taking your withdrawals in the following sequence. (Keep in mind, if you are under age 59½, additional early withdrawal taxes and penalties may apply.):
- If you are age 70½ or older, take any RMDs from Traditional IRAs or 401(k) plans. Failing to take RMDs results in a penalty equal to half the amount you were required to withdraw but didn't, plus interest.
- If you are under age 70½ or if you need more than the RMD amount to cover your retirement expenses, draw from a taxable account or increase withdrawals from your traditional retirement accounts. This preserves the tax-free growth potential of a Roth IRA.
- If you need additional income late in the year and don't wish to draw from an emergency fund, you can withdraw from a Roth IRA to avoid moving into a higher marginal tax bracket. Your tax advisor can help you monitor your tax exposure and select the appropriate strategy.
A Roth IRA's tax-free withdrawals and lack of RMDs make the account ideal for funding health care expenses late in retirement. "These are the instances where you really feel the benefits of your Roth IRA," Fahlund says. "You can draw down on this account when you need to, without paying taxes."
*These examples assume that your Roth IRA withdrawal is a qualified, tax-free distribution. These tax rates are hypothetical; be sure to also factor in your individual state taxes and regulations.
Proper planning can prepare you and your finances for the unknown changes that will occur during the next stages of your life, helping increase your control over your after-tax income during retirement. "Maximizing the flexibility of your plan now will help you approach the future with confidence that you are prepared to manage the unknowns," Fahlund says. "You can begin laying the groundwork now by saving as much as possible in all three account types—particularly Roth accounts—and adjusting your planned withdrawals as needed in your post-career years."
1 Go to the Social Security Administration's website for more on the retirementearnings test and exempt amount. Visit www.socialsecurity.gov.