Roughly 10,000 Baby Boomers reach retirement age every day.1 If you are a member of this generation and have started approaching your prime retirement years, you may visualize the transition as climbing to the top of the ‘retirement mountain’ — from the Accumulation of assets (the way up) to the Decumulation phase (the way down).
Over time, you’ve no doubt worked very hard to earn your money — and you don’t want to waste it by making uninformed decisions in retirement. You may have 25 years or more of the good life ahead of you, so it’s important to be as prepared and protected as possible.
Part of that preparation includes a thorough retirement distribution plan.
Retirement distribution planning is an ongoing, iterative process that can help you determine how to utilize your assets as an income stream after your work income has slowed or stopped. It’s essential to have a withdrawal plan that can meet your changing needs and expenses throughout your post-working years.
There are a number of key factors that make up an optimal retirement withdrawal strategy, and you may need to weigh them against each other to develop a plan that makes sense for your situation. For instance, are you more concerned with tax efficiency or with potential longevity issues? This will likely play a role in determining how and when you will take distributions.
As you think through these questions, consider using the “ABC approach”:
When developing your retirement withdrawal strategy, the first factor you should consider is asset location. Asset location refers to the optimal distribution of assets across different types of accounts to enhance overall tax efficiency.
There are three broad categories of investment account types. The first is pre-tax, which includes individual retirement accounts (IRAs) and 401(k) plans. With pre-tax accounts, ordinary income tax is only due when the assets are distributed to you. Roth IRA and Roth 401(k) accounts make up the second category; these types of accounts accumulate without tax, which means distributions are tax-free in retirement (if you play by the tax rules). The third and final category is taxable accounts, which incur capital gains tax when investments are sold, plus income tax on interest and dividends along the way.
Before you determine which of your particular investments (stocks, bonds, real estate, cash, etc.) should be held in which type of account, there are a few important income tax considerations to keep in mind. For instance, should you have high-earning stocks in your IRA or Roth accounts to maximize growth inside a tax-sheltered account?
And you might consider placing most of your fixed-income investments inside pre-tax IRAs, so the interest received on them is not taxed currently. Conversely, you may opt to have more of your dividend-paying stocks owned inside your “taxable accounts”, recognizing that dividends and long-term capital gains are taxed at lower rates than interest from bonds, which would be taxed at higher ordinary income rates.
Also, it’s important to ask yourself which account or assets you will liquidate first to sustain any cash needs. Will you tap into your Roth account first, because the assets are generally distributed tax-free? Or are you better off using those assets last, since they could conceivably grow tax-free for decades on end?
The optimal decision can vary depending on your unique situation, but most investors are generally better off taking money out of taxable accounts first before dipping into pre-tax IRA and 401(k) assets. Taxable accounts will only incur capital gains tax on the portion of the investment that is at gain, while pre-tax assets will be fully taxed at ordinary income rates.
Annual tax planning is crucial while entering and during your retirement years, particularly when determining the appropriate times to utilize each bucket (pre-tax, taxable or Roth accounts). Tax rates and your individual tax picture can change over time; understanding these changes and paying careful attention when developing your withdrawal strategy each year can really “pay off” when it comes time to spend some of your money.
Do you remember how much a candy bar cost at the corner store when you were a kid? How many multiples higher is that cost now? Several times higher, I bet. Inflation will continue to have the same impact on our costs each year, and today’s costs will likely double in total within the next 15 or 20 years at average inflation rates.
Inflation causes a dramatic decrease in the buying power of our saved dollars. So while it might feel ‘safe’ in the short term investing ‘conservatively’, you can risk not having enough of your money down the road when taking inflation into consideration, due to lower returns.
Additionally, if you follow the asset location process I referenced above, the overall allocation of your investment holdings may change dramatically during retirement, which will require good planning in advance. For instance, many investors likely want to keep a meaningful portion of their portfolios in stocks throughout retirement, as the potential for long-term gains can increase the chance that their buying power will keep up with inflation as they withdraw money. On the other hand, some investors might feel comfortable with a more conservative route, which involves primarily selling stocks during their early retirement years and preserving fixed-income investments. In the end, stock returns will likely beat inflation over time, whereas cash may lose, and bonds may struggle to keep up.
There are many competing interests to juggle, and the best answer will not be the same for all investors. It’s important to regroup with a financial and tax advisor to consider these strategies carefully and make the best decision for your situation.
From a tax-diversification standpoint, it’s smart to have at least some portion of your investment assets in each of the three, broad account types listed above. That way, you can be hedged against future changes in tax law and also have the opportunity to take advantage of the various tax treatments that can come with these accounts, based on which will be most advantageous to you at different stages of retirement.
To make the most out of your retirement distribution options, you may consider carefully converting some of your investment accounts into more tax-efficient accounts.
Pre-tax IRA and some 401(k) accounts can be converted into Roth accounts, which would move those assets into a category that can result in tax-free distributions down the road.
Keep in mind that the amount that is converted from a pre-tax account into a Roth account is considered to be taxable income in the year it is converted. In these types of situations, a good ‘tax play’ can often be made, depending on the current and future expected tax rate to be paid.
We often find that the best time for investors to conduct partial Roth conversions of pre-tax IRA or 401(k) assets is in their early retirement years. These years are often marked by low ordinary taxable income, especially prior to the start of Social Security payments or required minimum distributions (RMDs) from pre-tax investments.
While this may not be the case for all investors, there is a chance that your tax rate can go up dramatically after you cross these milestones. So you may benefit from slowly or carefully transferring some of those assets over the proverbial ‘tax fence’ in small amounts, rather than waiting until later and paying a higher tax.
The key to making your nest egg stretch throughout retirement isn’t only what you have — it’s how well you manage your cash flow. Developing and sticking with a flexible withdrawal strategy can help ensure that you won’t deplete the savings you’ve worked so hard to build. Keep in mind that there are many complex factors to consider when creating a withdrawal strategy. A financial advisor who is experienced and well-versed in these tax matters can evaluate your situation to develop a strategy that can help you finance all of your retirement dreams.