Retirement Withdrawal Strategy In The US: Simplified Guide for Beginners

By: Michael Carbone, CFA, CFP®

Transitioning into retirement can be overwhelming. Most workers have used their skills and knowledge to earn an income, for the better half of four decades! Now, instead of earning a relatively predictable stream of income, retirees must figure out how to best replace it.

In retirement, the way you extract funds from your savings becomes as crucial as how you've saved during your working years. Each withdrawal can potentially influence your financial longevity, exposure to financial risks, and the taxes you pay.

The challenge then is creating a retirement withdrawal strategy that's both sustainable and tax efficient. I believe that a thoughtful approach to spending down your money can significantly improve your likelihood of maintaining your lifestyle in retirement, while also reducing your financial anxiety and potentially maximizing any future inheritance left to your beneficiaries.

Understanding Withdrawal Rates

I believe that withdrawal rates can be an incredibly valuable tool for guiding retirees towards determining how much can be safely spent.

By embracing a responsible retirement withdrawal rate, typically defined as the percentage of your total financial assets being withdrawn annually, you can create a stable bridge between your working life's discipline and the freedom of retirement.

The “4% safe withdrawal rule” is often considered the optimal standard for retirees looking to maximize withdrawals with low risk of outliving their financial assets.

The 4% Rule Explained

The 4% rule is a simple, but potentially powerful guide to use when spending down your assets in retirement. The rule was developed by William Bengen when he concluded that the average retiree portfolio could sustain an annual 4% withdrawal (including an annual raise for inflation), with a very low risk of depleting their assets.

The rule was developed using historical market data, which brings into question whether 4% is the “right” number, as opposed to say 3.5% or 4.5%. This is highly debated in the financial planning world, which I don't find to be very productive. Why? Because everybody's situation is different:

  • The rule assumes the retiree is invested “normally”, with more than half of their money invested in stocks, and the rest bonds.
  • The rule assumes withdrawals are taken proportionally from stocks and bonds.
  • The rule assumes the retiree is only looking to maintain their lifestyle - potentially ignoring legacy, charitable, and other spending priorities.
  • The rule assumes the retiree has a constant need to withdraw from their assets (ignoring inflation). In reality, the timing of your cash needs may be less uniform. For example, if you retire prior to collecting social security, chances are that you'll need more from your portfolio during those years, etc.

Regardless of the argument for or against the 4% withdrawal rule, I believe it can be incredibly valuable for retirees - potentially serving as a guide to avoiding spending too much (or too little) during retirement. If you’re interested in learning how you can use this concept to “back-in” to a safe savings estimate, please feel free to watch the video I’ve created here.

Which Accounts To Withdraw From And When

The art of timing retirement withdrawals is crucial to preserving your savings for your later years. Strategic timing can optimize your tax liabilities, maintain investment growth potential, and manage the risk of running out of funds.

The conventional wisdom for funding withdrawals in retirement suggests beginning with depleting funds from taxable non-retirement accounts, followed by withdrawals from tax-deferred retirement accounts, and leaving tax-free Roth assets for last.

The intuition behind this is that the benefits of tax-advantaged accounts (e.g., IRAs, Roth IRAs, 401ks, etc.) may increase with time. Why? Because it offers your tax savings more time to potentially benefit from compounding investment returns.

That being said, this is a blanket approach – and while I do believe there is merit to following this tack, I generally believe that most retiree’s would benefit more by tapping the combination of accounts that best aligns with their tax and investment situation.

Get Familiar With Marginal Tax Rates

In determining the optimal combination of accounts to withdraw money from, it’s crucial to understand your tax situation. There are generally two ways the average retiree is taxed:

Ordinary income pays taxes at the federal (and sometimes state) level. Federal income taxes are assessed on a progressive scale. This means that the more ordinary income you have, the higher the tax rate. This is not retroactive. So, if your ordinary income exceeds a tax bracket, only the income above the bracket will be taxed at the higher rate. Common sources of ordinary income would be wages, a portion of social security, short-term capital gains and taxable interest earned outside of retirement accounts, pensions, and traditional retirement account distributions.

Long-term profits and qualified dividends earned on investments held in non-retirement accounts pay taxes at the federal (and sometimes state) level. Similar to federal income taxes, this tax is progressive (though on a different scale vs. income taxes). Depending on your income, these taxes are currently 0,15, or 20%. Other things being equal, these tax rates are typically lower than ordinary income rates.

The progressive nature of each of these taxes may potentially create tax-saving opportunities, but not without potential unintended consequences – it’s important to be aware of all potential outcomes when deciding where to pull money from.

I believe the most common potential tax-saving opportunities are:

  • During early retirement years, tapping retirement accounts for spending, at a relatively lower rate vs. what may be paid in the future when you’re required to distribute a portion of the accounts each year.
  • During early retirement years, converting pre-tax retirement dollars to Roth, at a relatively lower rate vs. what may be paid in the future when you’re required to distribute a portion of the accounts each year – or vs. what your future beneficiaries may pay.
  • Realizing long-term profits on investments held in taxable non-retirement accounts for spending and risk management, during years where taxable income is below the 22% corridor, to avoid paying a 15% federal capital gains tax.

I believe the most common potential unintended consequences of these decisions are:

  • Increasing the percentage of Social Security benefits that are taxable
  • Triggering IRMAA, which is an increase in your Medicare premiums

It’s important to weigh the tradeoffs to ensure there is an incremental benefit that outweighs any potential consequences of your decisions.

Which Investments To Sell And When

In addition to considering your taxes when deciding where to pull money from, your investment strategy should also be considered.

Generally:

  1. During “normal” periods of time, it may be wise to take income (dividends, interest, and part of our capital appreciation) off assets proportionately – this may help maintain an appropriate allocation, based on your needs for growth and liquidity.
  2. During long periods of market growth, it may be prudent to sell more, or all of your spending needs, from stock to control your stock allocation in a rising market.
  3. During recessions, it’s often smart to mostly use bonds and cash to meet spending needs – leaving stocks alone, as they will likely be down in value. This may help us to avoid “selling low.” Although past performance cannot guarantee future results, the bonds and cash may buy time for the economy to recover. Hopefully stocks have risen back up to better levels by the time you need to sell against them for income.

In Summary

  • The goal of any withdrawal strategy should be to maximize your likelihood of meeting long-term goals while minimizing your financial anxiety. The optimal retirement withdrawal strategy will ultimately depend on your personal situation.
  • The 4% safe withdrawal rate may be a great guide to avoiding spending too much (or too little) during retirement.
  • The conventional wisdom for funding withdrawals in retirement suggests beginning with depleting funds from taxable non-retirement accounts, followed by withdrawals from tax-deferred retirement accounts, and leaving tax-free Roth assets for last.
  • It’s important to understand how your withdrawals will affect your tax and investment situation. There may be opportunities but also unintended consequences for particular actions.
    • Tax savings are not valuable if they do not provide an incremental benefit vs. the potential unintended consequences created to attain them.

If you feel that you’d benefit from a complimentary consultation, click this link to answer a few questions. If you’re a good candidate for setting up a call it will bring you directly to my calendar to schedule some time.

I wish you the best of luck and hope to hear from you soon!

Michael

Important Disclosures

Any opinions are those of Michael Carbone not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change. This information is not intended as a solicitation or recommendation of any kind. Investments mentioned may not be suitable for all investors. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Diversification and asset allocation do not ensure a profit or protect against a loss.

Stocks offer long-term growth potential but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations and the potential loss of principal.

Investing in fixed income securities (aka “bonds”) involves certain risks such as market risk, if sold prior to maturity, and credit risk, especially if investing in “high yield bonds,” which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than their original cost upon redemption or maturity. Bond market values fluctuate inversely to changes in interest rates. In other words, if interest rates rise, after your purchase, you may receive less than your purchase price should you liquidate early, and vice versa. Bonds mature at face value and provide a fixed rate of return if held to maturity.

Financial and investment planning inherently involve potential tax and legal implications, with which we are generally familiar. We do not, however, practice as lawyers or CPAs and cannot give specific legal or tax advice. You should always consult with your tax advisor, or your attorney, when making complicated legal or tax decisions, however, we’re glad to work with your tax or legal professional to help you meet your financial goals.

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