The right way to withdraw money matters. We often talk about how to save for retirement. That is, after all, the occupation necessary for everyone during their working life. Whether you follow the 60/40 strategy, put your money in real estate or simply buy all the S&P 500 Index shares you can, how you save for retirement matters. There are many things to consider before deciding on the right withdrawal strategy. You may also want to work with a financial advisor who can help you set up the right retirement withdrawal strategy.
defer, defer, defer
This is less a strategy than an overall mindset, but it’s still important to discuss. One of the biggest moving things when it comes to retirement is your network of age-related deadlines. Most tax-advantaged retirement accounts require minimum distributions at or around 72. Social Security kicks in at age 62, but must be started at 70. There is no age limit on your regular investments, as well as your Roth accounts.
Your exact time frame will depend on individual circumstances and income needs, but a good rule of thumb is this: procrastinate. In virtually all cases, your retirement options will increase in value if you can stop taking withdrawals. Social Security pays more if you start collecting at age 70 than at 62. The more money you can keep in your retirement accounts, the more you can maximize compound returns. For any given account, waiting longer usually means more money in the long run.
Now, postponing everything isn’t a viable strategy for most retirees. The whole point is that after all this is the money you will be living on. However, when income and circumstances allow, it’s a good strategy to keep your money for as long as possible.
Withdrawal for sequence risk
Sequence risk, otherwise known as “sequence of returns risk,” is the risk posed by market fluctuations during your retirement.
In essence, it is the risk that your portfolio will suffer a market downturn at the same time that you need to withdraw from it. This can happen in short bursts, for example, if you need to make withdrawals at the beginning of the year during a short downturn. However, this is usually discussed in annual terms. In annual terms, it’s the risk that your early retirement will coincide with a recession.
In all cases, however, the basic risk is the same: you will have to withdraw money when the market is down. This forces you to take a potential loss on your assets and leaves your portfolio with fewer assets to recover its value when the market bounces back.
There are many ways to plan for sequence risk. However, a sound approach is to maintain a diversified portfolio, with money placed across multiple asset classes. For example, let’s say you have investments in both stocks and bonds. Those markets usually move counter-cyclically against each other, allowing you to sell your stocks if your bonds are down and vice versa. A diversified portfolio will also give you capital to tap into during down markets, so you can sell strong assets and replace weaker assets while their prices are low.
Whether you approach it with a diversification strategy or another approach, be sure to plan for sequence risk management. This can take a large chunk out of an unprepared portfolio.
tax benefit maximization
Broadly speaking, retirement portfolios fall into three categories:
A tax-advantaged portfolio is one that does not have any special tax advantages. You invest with money on which you have paid taxes and when you withdraw them you will pay taxes on the profits of the account.
A pretax portfolio, such as a 401(k) or an IRA, is one in which you have invested with money without taxes. Your contributions to this account are fully tax-deductible, but you pay taxes on the portfolio’s gains when you withdraw them during retirement.
Finally, a post-tax portfolio, such as a Roth IRA or Roth 401(k), is one in which you have invested entirely with after-tax money. Your contributions to this portfolio were not tax deductible, but you do not pay taxes on the account’s profits when you withdraw them during retirement.
One strategy in retirement, then, is to structure your withdrawals to allow your most feature-rich accounts to grow the longest. Historically, finance experts have recommended that you withdraw funds in order of taxation. In other words, withdraw from your fully taxed accounts first so that your tax-advantaged accounts can grow more. Then take withdrawals from your pre-tax accounts to grow your highest profit, after-tax accounts. Finally, take withdrawals from Roth accounts on which you won’t owe any taxes.
Some experts suggest other, more sophisticated approaches, such as Fidelity’s Whole-Portfolio Tax Planning Math. But the bottom line remains the same: There are three tax positions you can have in your portfolio, depending on the nature of each account. Maximizing the value of those portfolios while minimizing the tax impact of your withdrawals takes planning, but it’s worth it.
deposit earnings first
Broadly speaking again, any investment asset has two footprints in your portfolio: Return and Yield. Your return is the money you make by selling the asset for a profit. Your yield is the income you make by holding those assets over time. Income includes income such as interest payments from bonds and dividends from stocks.
For many retirees, this type of income may be the first line of your plan. When factored in with payments like Social Security and long-term assets (if you own a rental property, for example), it’s a great way to establish steady, long-term income for your retirement. More to the point, this is a great way to generate retirement income without having to sell assets.
By maximizing yield rather than return, you can make money out of your retirement portfolio without depleting its assets. This will reduce how much you lose in the value of your retirement account over time, potentially increasing its longevity significantly.
Saving for retirement requires work and planning, so much so that we often forget about the second step in retirement, making withdrawals. While this is an area with lots of potential options, there are a variety of strategies you can follow when deciding how and when you should withdraw retirement funds. The right one for you depends on how much money you may need.
tips for retirement
- The truth is, it can be complicated. There can be a lot of math and knowledge involved in maximizing tax benefits and extracting returns. A financial advisor can make it all easier for you by helping you plan and manage your retirement strategy. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can interview your advisor matches for free to decide which is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Check out the no-cost Retirement Calculator for a quick estimate Here are four possible ways to plan your retirement withdrawals. There are many ways to approach this, so perhaps the best place to start is with a proper plan.
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Eric Reid Eric Reid is a freelance journalist specializing in economics, policy and global issues with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of intangible issues, with an emphasis on analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, including Sao Paulo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist, Eric worked with a pro bono specialty in human trafficking issues in securities litigation and white-collar criminal defense. He graduated from the University of Michigan Law School and can be found on any given Saturday in the fall cheering on his Wolverines.