Withdrawing Money During Retirement

The following is an excerpt from Personal Investing: The Missing Manual.

After you spend decades living off a paycheck and saving money for retirement, selling investments so you have spending money can be downright unsettling—it's the exact opposite of what you've done your entire life. In addition, you worry about having to sell investments during a down market and hurting your portfolio. Meanwhile, you have enough on your mind wondering whether you'll get to the local diner in time for the early bird special. You can balance withdrawing cash from your portfolio and making sure your money lasts. This section tells you how.

Figuring Out What You Can Spend Each Year

The whole point of a retirement plan is to save enough money so you can live the way you want during retirement. However, when you retire, you have to be realistic. If you want your money to last, you can spend only a certain amount each year. That amount depends on the sources of income you have:

• Social Security benefits.
• Pension benefits, if you qualify for a pension.
• Part-time work.
• Income from your portfolio.
• Withdrawing principal from your portfolio.

If you're lucky and frugal, you may receive enough money from the first four sources to pay your living expenses. However, most people have to withdraw principal from their portfolios to make ends meet. If you fall into this category, here's how to figure out how much you can withdraw from your portfolio in income and principal each year without worrying about running out of money:

1. Figure out the real return you expect from your portfolio between now and when you die.

The real return is the investment return you expect, reduced due to the effects of inflation. For example, if you expect to earn 7% and inflation is 3%, your real return is 3.9%. (To calculate the real return for yourself, use this formula: (1 + investment return)/(1+inflation rate) – 1, and then multiply by 100 for a percentage.) For simplicity, this example assumes the real return is 4%.

2. Use the real return you calculated to figure out how much you can withdraw during your first year of retirement.

Say your portfolio is $500,000. Multiplying your portfolio balance by the real return ($500,000 x 4%), you see that you can withdraw $20,000 the first year.

3. Calculate the withdrawal for each subsequent year by multiplying the previous year's amount by the inflation rate.

In this example, you'd increase your second-year withdrawal by 3%, making it $20,600. You'd withdraw $21,218 in the third year of retirement.

Note: If you opt to withdraw only the income from your portfolio, you may be tempted to weight your portfolio heavily on the bond and REIT side of things. Although you'll be able to withdraw more each year, your portfolio won't grow fast enough during retirement, and you'll run out of money sooner.

Creating a Retirement Paycheck

The withdrawal strategy in the previous section assumes that the annual return is the same each year. But you know that the market has good years and bad years. That's why you set up a cash reserve to cover several years of living expenses. That way, you won't have to sell investments at a loss to pay your bills. As long as you have a cash reserve, you can set up automatic withdrawals to act as a replacement for the paycheck you grew accustomed to.

Using the $20,000 first-year withdrawal from the previous example, here's how you use your cash reserve to set up a retirement paycheck:

1. Set aside a cash flow resesrve for 5 years of living expenses.

To keep things simple, multiply your first year's withdrawal by 5 (totaling $100,000 in this example).

2. Put 1 year's worth of expenses ($20,000) in an ultra-low-risk savings account, like a money market account.

You don't earn much interest, but you don't lose any money either.

3. Invest the second year's living expenses (another $20,000) in a low-expense, short-term bond fund.

Invest in high-quality bonds to keep your risk low (see Section 7.2.1.1). You'll earn a better return than you do in the money market account without much additional risk. If you invest in municipal bonds, your taxes on the income will be low, too.

4. Invest the remaining 3 years of living expenses in short- and intermediate-term bond funds.

These investments are still relatively low risk, but provide slightly higher returns than the rest of your cash reserve, which helps protect your money against inflation.

5. Set up a monthly transfer from your money market account or savings account (the one in step 2) to your checking account so it acts as your retirement "paycheck."

You can live on this money just like you did with your paycheck while you were working. In this example, the monthly amount starts at $1,667. Each year, you increase your monthly withdrawal for inflation, so the monthly amount in the second year is $1,717.

6. Every year, replenish your cash reserve.

Remember, your cash reserve has to increase for inflation. So, if you started with $100,000, the next year's reserve would have to be $103,000.

Because you have to sell investments to refill your cash reserve, choose what to sell wisely. If you can sell some investments without taking a loss, sell the investments that also keep your overall asset allocation on target. You can also use these sales to get rid of investments that aren't meeting your expectations. If stocks and bonds are both in the toilet, sell short-term bonds first (they drop the least of any duration bond, as explained on page 138). That way, you give the rest of your portfolio time to recover.

Because you have 5 years of expenses in your cash reserve, you have time to wait out a bear market. If all your investments have lost money, you can wait before replenishing your cash reserve. For example, you may choose to delay adding to your cash reserve for a year. Then, when the market recovers, you can sell investments to top off your reserve.

Tip: If you have money in traditional IRAs or 401(k)s, you have to take required minimum distributions. When you refill your cash reserve, be sure to withdraw your RMDs first. After that, it usually makes sense to withdraw the additional money from your traditional IRAs and 401(k)s, so money in Roth IRAs can grow for as long as possible. (Roth IRAs don't have RMDs, so you can leave the money in as long as you like.)

Comments

[Starshard0]

Having to sell investments during retirement would really bum me out. Doing all that work and then watching your principle dwindle away. It's definitely an unsettling though. Hopefully I can make enough outside of the principle that I don't have to withrdaw any.

[Kaseyd]

I'm currently reading "The Buckets of Money Retirement Solution: The Ultimate Guide to Income for Life" by Ray Lucia (http://www.RayLucia.com). I had just finished reading his older book "Buckets of Money". Lucia has an approach similar to the "Missing Manual" book above.

Here's my very simplistic overview: Lucia proposes three "Buckets". A short term bucket (say 5-7 years) with cash and laddered CDs, an intermediate term bucket (7 to 12 years) with longer term CDs and managed bonds, and a long term bucket (over 12 years - with equity and real estate). He proposes you use bucket #1 first. When bucket #1 is depleted, turn bucket #2 into a new bucket #1 and deplete it. Bucket #3 stays invested for the long term; withdrawing partially to begin a new bucket #2.

This approach has much appeal, as your immediate future is more secure and you can feel more comfortable letting your equity investments ride out a bear market. You don't "have to sell" equities every year and you don't do what Ray Lucia calls "reverse dollar-cost averaging".

The only part of the buckets of money plan I dislike is the strong pitch for annuities to supplement the first two buckets. I'm not a fan of annuities, but Lucia does make some good points about how they might fit into someone's retirement plan.

[Matt]

As much as you need a plan to save for retirement, you also need a plan on how to take out money in retirement. Studying the tax code and understanding what you need to do and how to take your money out to minimize taxes is the goal and necessary.

As in my fathers case since he turned 70 1/2 and needed to start taking money out of his traditional IRA he felt that it would be wise to have an accountant to look at this and advise him what is the best.If he did not take enough out he would be penalized. Too much and he is paying too much in taxes.

This is probably prudent in that in 20 years the tax code will change when i am thinking of retiring and who know what I will need to do to minimize issues.

[MBTN]

Very informative post. Right now, I am in the accumulation phase of my life, putting money away for retirement so I haven't thought too much about taking money out. This seems like a good strategy for balancing the need for short term stability with the fact that you still need to allow your money to grow in retirement.

It seems like a variation of this strategy would make sense for savings, too. For instance, use a money market for short term needs/emergency fund, use a short/intermediate bond fund for medium term goals like saving for house down payment or other large purchases, and use some equity type fund for long term goals like college or retirement.

[Old Limey]

I am over 70 1/2 and so is my wife. We have no choice whatsoever this year but to take almost $150K out of our IRAs and pay taxes on the withdrawal. This is mandatory. In our case we have some withheld for state and federal taxes and the rest goes into our Trust account which is taxable. We don't have to actually sell any investments, aside from money for the tax withholding, we can just transfer shares from one account to another.
The good thing is that the money withheld for taxes, even though it is only taken out late in the year, is treated by the IRS and the State as if it were received in monthly instalments throughout the year, so there are no extra penalties or interest for not making quarterly tax payments.

[Georgia]

I can live easily on my SS and 2 small pensions, even saving some in the process. In the 4-5 years since retirement, I have withdrawn over $15k and am only down $2k. This is because I do not do monthly withdrawals. In mid-December each year, except for 2009, I withdraw whatever I need to do a fix on my home. This keeps interest accumulating. (Usually I only withdraw the minimum.)

I will be okay for a few years, but things are not going to stop going up in price. In fact, the value of my income will drop considerably with all the price raises. That's why I am trying to save almost 25% of my SS & pensions. This should keep me going for a few years. After that, I will take each day as it comes. I do not have a fortune, but I feel God has blessed me exceedingly and I am thankful for what I did get saved.