To retire as you envision, you must craft an astute plan to manage your income.
You may think you’re used to income planning in your current life, so how different could the transition to retirement be?
Managing your income in retirement is more complex and nuanced than doing so while employed. When you retire, you have to think about a withdrawal strategy, maintaining tax efficiency, and ways to respond to changing market conditions.
Since all those elements are a new experience, you’ll need to create a deliberate, strategic plan.
What do you need to consider to manage your income in retirement effectively?
Let’s break it down.
Create A Resilient Retirement Withdrawal Strategy
Nearly everyone thinks about retirement planning in terms of how much they need to save. People believe they can afford to retire once their retirement account balance reaches a specific dollar amount.
Implicitly, they equate their retirement account balance to a regular “paycheck,” but there’s much more to it. You must consider the particulars of creating a stream of income from each of your retirement accounts.
That’s where your withdrawal strategy comes in.
What’s A Retirement Withdrawal Strategy?
A retirement withdrawal strategy helps you plan how much to take from each account and at what time.
Think about your retirement withdrawal strategy as a blueprint for your personal retirement savings. It illustrates a detailed plan that provides an overview of all the savings you have at your disposal and optimizes how you’ll use them.
For example, when building a house, you wouldn’t put an oven in a bathroom. You have to think about the space, the function it serves, and the impact on your life.
The same is true for your retirement accounts!
You need to understand the types of accounts you have, their unique functions, and how you can use them in the most appropriate ways for you.
You likely have money in various accounts, each governed by different rules. Things like when you can withdraw without incurring penalties and how those withdrawals are taxed. Coordinating all those moving pieces (along with other retirement income like Social Security, pensions, annuities, etc.) allows for a much more effective use of your retirement dollars.
So, how much should you draw from your retirement plans like a 401k, Roth IRA, and taxable brokerage account to support your retirement lifestyle?
The answer depends on two factors:
Where you store your savings, and
How much income you need.
Let’s zoom in on each of these points.
Analyze Your Retirement Savings
Crafting a personalized withdrawal strategy starts by understanding what savings you have, where you put them, and the taxation rules for each account.
Taxes play a central role in determining the proper withdrawal strategy for your situation. You can save a considerable sum throughout your golden years by understanding the tax implications of your distributions.
Breaking Down Tax Buckets
Here are some of the “account types” you may have:
Pre-tax (401k, IRA, etc.) – Most retirees keep the bulk of their savings in pre-tax accounts. You may also hear these accounts described as tax-deferred because when you withdraw the money, it’s included in your taxable income.
Tax-free (Roth) – By now, most people understand the considerable benefits of Roth accounts, namely tax-free income in retirement. As long as you follow the rules, you won’t owe anything on withdrawals bringing more freedom and flexibility to your plan.
Taxable (Brokerage, real estate, etc.) – Money you hold outside of tax-advantaged retirement accounts is subject to taxation differently. It’s not based on when or whether you withdraw from the account but on what you do with the investments inside the account. Here, it’s important to minimize the amount that is taxed as income and at the more favorable long-term capital gain rates.
Other (HSA) – Health Savings Accounts deserve their own explanation since they don’t fit into any of the typical buckets. They are arguably the most tax-efficient savings vehicle you have because you can deduct contributions, which grow tax-free, and are withdrawn tax-free when you use them for qualifying medical expenses. Because Medicare premiums are a qualifying medical expense, HSAs can significantly boost your regular withdrawal strategy.
Taxes Don’t Happen In A Vacuum
Not only do you need to consider how your money is taxed when you withdraw it to spend in retirement, but you also need to think about how your withdrawals will impact other tax items.
The foremost considerations are Social Security benefits and Medicare premiums.
Your Social Security benefits are taxed at either 0%, 50%, or 85%, depending on your other income. In much the same way that tax brackets are progressive, so is the taxability of your Social Security benefits.
For most retirees, Medicare Part A is premium-free. However, Parts B and D have premiums that increase in price as your taxable income rises.
To create a tax-efficient withdrawal plan, you must coordinate each element with a plan that spans decades.
Understand When And How To Make Adjustments
While a good withdrawal plan will account for things like your spending needs, taxes, inflation, and market fluctuations, it does so based on projected estimations of an unknown future.
Once you’ve decided how to withdraw from your savings and begin to do so, all of those factors may drift from what you expected. If one or more of them drift too far, it may be necessary to make adjustments over time, and there are many ways to accomplish that goal.
Our favorite method draws from the guardrail approach.
The Guardrail Approach To Retirement Withdrawals
The guardrail approach provides a structured set of guidelines for:
Knowing when you need to make adjustments. It’s not necessary to alter your plan every time the market moves. Establishing boundaries or guardrails upfront empowers you to understand when you need a change and when you don’t. This understanding can provide comfort given the emotional response that volatile markets often elicit.
Deciding how much of a change you need to make. Even after you decide you need to act, the question of what you will do remains. Again, it’s helpful to have a set of rules in place in advance.
With this method, you set guardrails around your portfolio and adjust your withdrawals if and when you hit those buffers. If you don’t hit the buffers, you continue as normal. Let’s explain the basic rules and then highlight an example.
Suppose you start retirement with $1,000,000 in savings and plan to withdraw 5%, or $50,000. Each year after that, you’d increase your withdrawal to keep up with inflation. For example, if inflation is 6% in your first year of retirement, you’d withdraw $53,000 in your second year.
This is a pretty standard approach.
However, it leaves you exposed to a core risk, inflation. Inflation rose to 9.1% as of June 2022, which poses a serious threat to portfolio longevity. If inflation remains high and your withdrawal grows too large, you could deplete your savings too soon.
There are other risks retirees must contend with, like bear markets. What happens to your withdrawal plan in a prolonged period of bear markets or recessions? Or what if you’re battling simultaneous market risks at once?
How Guardrails Help Keep You In Control
Guardrails help you protect yourself from situations like the ones above. Here’s how it works:
Once you set your initial withdrawal rate, in this case at 5%, you set your guardrails at a relative 20% above and below, so 4% and 6%.
If your withdrawals push outside these boundaries, you cut (or increase) your withdrawal for the year by 10%. Otherwise, no adjustments are necessary, and you simply continue to take your inflation-adjusted withdrawals.
For example, assume that after 6 years, your savings grows to $1,100,000, and your yearly withdrawal increases to $57,000. Do you need to adjust? Let’s check!
What are your guardrails?
4% of $1,100,000 is $44,000
6% of $1,300,000 is $66,000
$57,000 is between the guardrails, so no adjustment is required. It’s as simple as that—no need to worry about every twitch of the market or every headline about inflation.
What if inflation remained high and your withdrawal should be $78,000? Now you are outside of the upper guardrail and need to adjust. By how much? 10%.
10% of $78,00 is $7,800, so you’d withdraw $70,200. Notice that even with the reduction, you aren’t inside the guardrail?
One of the benefits of this strategy is that it provides you with a system for making smaller, gradual adjustments as needed rather than making sudden and dramatic shifts in your plan. This approach makes it much easier to stick with while still providing a significant improvement over ad hoc changes or none at all.
Why Withdrawal Planning Is So Critical In Retirement
You’ve worked so hard to build your nest egg. Protecting it by being conscious and adaptable is a great way to get the most out of it and make the best out of your golden years.
To see how you can incorporate these ideas into your own plan, reach out to us. We’d love to walk you through it.