How To Create A Retirement Withdrawal Strategy That Maximizes Your Nest Egg
You've been saving and investing diligently for decades, and now you've retired. Congratulations are in order!
But now what?
- With your income held in multiple accounts, which should you draw from first?
- How much makes sense?
- When is the best time?
The answers require you to create a retirement withdrawal strategy. Here’s how our team at Step by Step Financial goes about helping clients build theirs.
What's A Retirement Withdrawal Strategy?
A retirement withdrawal strategy is a plan to fund your retirement that maximizes your money while minimizing the taxes you pay. Sounds simple, but the reality is far more complex.
For example, if you just remove money from pre-tax accounts, like a 401k or traditional IRA, the IRS taxes it as ordinary income.
If you take out too little money or leave it in your account for too long (aka forgetting about your RMDs), you’ll also face ordinary income tax (plus some hefty penalties).
To avoid a “tax bomb” in retirement, you want a healthy mix of investments with different tax treatments you can leverage. You've got several types of investments in your portfolio, each with its unique tax treatment: 401k, IRA, Roth IRA, brokerage account, real estate, etc.
Which is a great thing—you can use them strategically to help you grow your nest egg, minimize taxes, and ensure you have plenty of money to last throughout retirement.
But how do you know the “right” amount of money to withdraw from each account? And when should you take those withdrawals? These questions must be answered to ensure your nest egg lasts through retirement.
The Three Types of Tax Treatments and How They Work
If you want to get some answers regarding your retirement withdrawal strategy, you need to know the type of investments you have and how the IRS taxes them.
1. Tax-deferred Investments
- Traditional 401k
These accounts offer pre-tax contributions and tax-free growth, but distributions count as ordinary income.
It's essential to manage your taxable income in retirement as it spills over into many areas of your financial strategy: taxes on Social Security benefits, Medicare premiums surcharges (IRMMA), additional investment taxes, eligibility for tax credits and deductions, and more.
These accounts also have required minimum distributions (an IRS-mandated amount you must remove from the accounts each year) once you turn 72, so keep that in mind because forgetting could cost you big time: a 50% penalty plus ordinary income tax.
2. Taxable Investments
- Brokerage account
These accounts don't have tax benefits per se, but how they're taxed is unique. You pay taxes when you sell an investment for a gain and pay capital gains tax.
If you hold the investment for a year or less, you pay the short-term capital gains rate. Any asset held for a year or longer is taxed at the long-term capital gains tax rate. The long-term rate, a current max of 20%, is more favorable than the tax on short-term gains, which get treated like ordinary income, and those rates go as high as 37%.
3. Tax-free Investments
- Roth IRA
- Roth 401k
You funded these investments with after-tax contributions, so they offer tax-free growth and tax-free withdrawals (if qualified). Plus, unlike Roth accounts, HSAs (Health Savings Accounts) actually have triple tax benefits!
Creating a coordinated strategy for each gives you more flexibility and opportunities.
Why We Love The Bucket Strategy
The bucket strategy is a great way to visualize and prepare for the short, medium, and long-term income needed in retirement.
The bucket strategy segments your wealth into different categories you can draw from at various points in your retirement journey. The categories have two defining characteristics: time and risk. Let’s take a closer look.
Bucket #1: Guaranteed Income
The first bucket centers on guaranteed income that doesn’t rely on market returns, including:
- Social Security
Bucket One's main objective is safeguarding your assets. Because it aims to reduce risk and offer a cash reserve, think of it as the "just in case" stream of income.
You should strive to have sufficient funds in this bucket to offset any losses brought on by a market slump. As a result, if your investments don't perform as you had hoped, you can withdraw more money from bucket one and replenish it later when they improve.
Bucket #2: Middle Retirement
Your allocations may have heavily favored equities as you planned for retirement, which makes sense. Investing largely in stocks provides the potential for growth in your portfolio.
However, your allocation and risk tolerance change as you approach or reach retirement. Risky stocks likely shouldn’t make up 90% of your portfolio. To maintain your nest egg over the long term, you can maintain a balance between safe, moderate, and riskier investments.
Around 10-15 years into retirement, the second bucket focuses entirely on developing moderate-risk securities, such as:
- Bonds, like fixed-term bonds
- Dividend-paying stocks
- Real Estate Investment Trusts (REITs)
Most of your nest egg will probably reside in these assets because they should keep up with inflation (and ideally beat it).
The objective is to assume moderate risk, increase your nest egg, and avoid suffering significant losses due to market conditions.
Bucket #3: Long-Term Planning
Spending two to three decades in retirement is not unusual. As a result, it's essential to siphon out a portion of your nest egg for long-term growth planning.
For your portfolio to last 25 years or more, you’ll want to invest a portion of it in riskier, growth-oriented stocks. This additional risk increases the long-term value of your nest egg with the help of the other two buckets.
What should you invest in? Building a diverse portfolio is important since it exposes you to domestic and international markets, large- and small-cap stocks, different market sectors, etc. The typical investing guidelines still apply.
The third bucket has two different functions:
- Boost the value of your retirement fund
- When necessary, aid with replenishing the other buckets.
Although bucket three is more volatile, it also has the longest window of opportunity for long-term gains. You might also use bucket three to help you leave a legacy, such as giving to charity or leaving your children an inheritance, depending on your growth objectives.
How Do I Make a Retirement Withdrawal Strategy Work for Me?
Your retirement savings strategy was relatively easy while you were working—save as much as possible. Now that you’re in retirement, it’s time to map out what you intend to spend.
Create a comprehensive spending strategy that accounts for all your expenses, like living costs, taxes, entertainment, travel, gifts, insurance, health, savings, and more.
You can also consider looking at fixed income sources like Social Security, a pension, or an annuity. Knowing where those income sources fit into your plan can help bring context to your strategy.
Creating A Custom Retirement Withdrawal Strategy That Suits Your Needs
Everyone's retirement strategy looks different, including yours. We can help you develop a comprehensive retirement withdrawal strategy to turn your savings into spendable dollars.