Retirement planning is often summed up into a single question: How much money do I need to retire?
Unfortunately, this question leaves many well-intentioned retirees far short of the actual goal. While understanding how much your retirement may cost, it’s just one part of a complete, sound retirement plan.
That plan should be the real goal, because it will also tell you how to properly start drawing down assets in retirement. A complete retirement plan will tell you how much money you can spend each year in retirement, how much tax you will pay, and where the money is going to come from.
These are simple, common questions for retirees, but answering them is anything but easy. To do so, you will need to have an understanding of competing issues such as taxability, investment performance, retirement income sources, risk tolerance, and projected longevity. You’ll then need to weave these into a strategy that meets both your short and long-term needs.
Here are 5 steps you can take to creating a complete plan for your retirement — including how you’ll start drawing down assets when you need them.
Determine How Much You Actually Spend Each Year
The first step to a good retirement plan is often to evaluate your current and projected annual expense needs. Painting a clear retirement budget allows you to begin planning for where the money will come from to meet this need.
One way to evaluate what your expected expenses will be is to use a simple rule of thumb. A popular guideline is to assume you need approximately 75-80% of your pre-retirement spending need in retirement.
If you spend $100,000 per year prior to retirement, for example, this rule of thumb suggests you need $75,000 to $80,000 per year in retirement.
This simple strategy may work for some, but it can leave others wildly off the mark. A more comprehensive approach would be to create a budget that reflects your current, known expenses and a projected budget to clearly identify what you need to cover your short-term and long-term costs.
Make sure to include expenses such as housing, healthcare, real estate taxes, travel, food, household expenses, and so on — and consider how those expenses might change once you stop working. In addition, you can plot non-annual expense needs such as college, weddings, big vacations, gifts to children, and/or gifts to charity.
Once you have a clear understanding of your expense needs, the next step is to evaluate what you’ll likely owe in income tax.
Gross Up Your Annual Expenses by Projected Income Tax
Income tax plays an important role in retirement planning. The difference between the amount you need to meet your annual retirement needs and the amount you need plus the income tax you’ll owe may be materially different.
If your annual retirement need (or the amount of money you must have to cover your costs) is $100,000, for example, you should add in an additional $17,647.06 worth of spending each year just to cover your income tax bill (assuming a flat 15% tax bracket).
Including an estimate for income tax is the prudent thing to do when considering your retirement plan. But getting that estimate requires you know what percentage tax rate to use, and that can be difficult to correctly identify.
The various rules and regulations regarding the taxation of different income and investment sources may make grossing up for taxes tricky. Not to mention, you’re estimating a future rate for the tax bracket you’ll be in during retirement and changes to tax laws that might impact those estimates can happen any time.
To illustrate how tricky this may get using one example, we can evaluate the taxability of Social Security income. Social Security income (depending on your filing status and income levels) may not be taxed at all. Alternatively, up to 85% of the total amount of Social Security received may be taxed. Or some other amount in the middle. The taxation of Social Security may be further complicated by the fact that you may elect to receive it early, or may not choose to receive it until you’re 70 years old. It may make sense to lessen your income by deferring Social Security and distributing assets from other accounts.
Ultimately you will need to decide which level of detail you want your retirement plan to have. Simply plans may use a rule of thumb. More complete plans may contain a detailed analysis of each tax year to determine how much tax you will actually pay.
Reduce Your Reliance on Your Nest Egg with Other Income Sources
Once you understand how much money you need each year in retirement after considering both your expenses and your potential tax burden, you can look at how to reduce your dependency on drawing down assets by funding your lifestyle with other income sources first. Common income sources in retirement include Social Security benefits and pensions.
Social Security is flexible in that you can often elect to begin receiving your benefit as early as 62 or as late as 70. A pension may also have some flexibility, with options that could include a life-only benefit that will pay for only as long as you are alive, or a joint benefit that may pay for as long as your and someone else (often a spouse) is alive.
Continuing our example from above, let’s assume you need $118,000 per year in retirement ($100,000 in expenses, plus $18,000 for income taxes, rounded up from $17,647.06). If your Social Security benefits add up to $30,000 per year and you have a pension that distributes $15,000 per year, you can reduce your need to draw down from assets to cover all your costs.
What is left, after reducing your total annual need by these other income sources, is a net need of $73,000. That’s what you’ll actually withdraw from your investment portfolio each year.
But the less you withdraw from that portfolio each year, the more you can continue to take advantage of compounding returns on the assets that remain invested – possibly making it less likely that you’ll run out of money in your lifetime.
This makes it important to carefully analyze where other income sources could help cover your costs, and consider using those first so you can let your investments continue to potentially grow.
How to Withdraw from Investments and Other Accounts
Generally speaking, the withdrawal of retirement assets can be summed up in a few rules of thumb:
- Spend down taxable assets first, tax-deferred second, and tax-free last
- Spend down lower-earning assets first and higher-earning assets next
Taxable First, Tax Deferred Second
Funds in a non-retirement brokerage account may be more advantageous to spend down as the tax impact of a liquidation may be considerably less than that of a 401(k) or IRA asset.
When you sell a non-IRA asset, you are subject to capital gains tax on any profit (or loss). If the profit is a long-term capital gain, the gain is subject to preferential long-term capital gain treatment. Short-term gains are subject to ordinary income.
Either way, the fact that you have accumulated non-retirement savings likely means you have already paid tax on some or all of the asset. This means that some or all of the asset may come back to you as a tax-free return of your own money.
If you are simply getting your own money back, and therefore do not need to pay tax, you may end up with a lower tax bill. Non-retirement accounts may further be more advantageous depending on when you retire, as they can be accessed at any age and any time without penalty.
Assets in an IRA may not be eligible to be used to supplement a retirement need for those who retire prior to reaching 59.5 years old. IRS rules state that for the most part, distributions from an IRA prior to age 59.5 are subject to ordinary income tax and 10% penalty. For those with a 401(k), special rules may permit penalty free withdrawals as early as 55.
If you withdraw from a non-retirement account to pay for retirement, you allow these retirement assets to continue to grow tax-deferred. Eventually, at age 70.5, the IRS mandates that you begin taking money from non-Roth retirement accounts in the form of required minimum distributions (RMDs), even if you don’t want to or don’t need the money.
The final accounts that may be considered are tax free assets, such as a ROTH IRA. Assets in a ROTH IRA are tax deferred — and if distributions meet certain requirements, they’re tax-free.
Further, assets in a ROTH IRA may be the best thing to inherit. Assuming that you can meet your income needs via other assets, it may make sense to let the tax-free bucket continue to potentially grow so you can leave this account to your heirs.
Lower Earning First, Higher Earning Second
This concept allows money that makes the best return earn the most for the longest period of time. Unfortunately, knowing what will perform best and what will not perform best is difficult.
Historically speaking, lower-earning assets include assets such as cash, money markets, CDs, and other fixed income instruments (like bonds). Higher-earning assets typically include equities (like stocks), including domestic, international, and emerging market equities.
Following our example from above, one strategy might be to keep a certain number of years’ worth of the money you need in retirement in a lower-earning, less-volatile asset. For example, you could hold 5 years’ worth of the income you need (or $365,000 based on our example of $73,000 per year discussed above) in a lower-earning asset or even one you expect to see zero growth in to minimize risk of loss.
Knowing that your next 5 years of retirement income was readily available, it may make sense to invest other assets in a more aggressive portfolio that may allow for potential growth.
The combination of a short-term and long-term investment strategy should be implemented in conjunction with your personal investment risk tolerance as well your other goals and objectives.
Review Employee Stock Options and Other Types of Employee Stock Ownership
Depending on the type of stock ownership you have and the rules regarding taxability, the final after-tax proceeds you receive after selling the stock may be materially different. Even more, the decisions you make regarding when to exercise, sell, and reinvest the proceeds may have a big impact on the overall outcome of your retirement.
You might want to follow the same track as mentioned above in step 4: spend after tax-assets first, specifically those with the lowest tax impact, followed by assets that are taxed as ordinary income.
To do so, you need to know the tax implications of each type of stock ownership, a task which can be daunting. Here is a quick recap (to read the long version, click here):
- Long stock – Subject to short and long-term capital gain (or loss) rates
- Restricted stock (83(b)) – Subject to capital gain (or loss) rates
- Restricted stock units – Subject to ordinary income
- Non-qualified stock options – Subject to ordinary income (plus payroll tax)
- Incentive stock options – Potentially subject to AMT, ordinary income, and/or capital gains rates
- Employee stock in a retirement plan – Potentially subject to ordinary income and/or capital gains rates
The complexity of tax treatment may be complicated by how many types of stock you own, and the decisions you have previously made. It may further be complicated by forced decisions such as retirement exercise periods and/or expiration dates. These are all things that should be included in a sound retirement income strategy.
Drawing Down Assets in Retirement
Drawing down assets in retirement may be considerably more complicated than one simple rule of thumb can address. In fact, to draw down assets in retirement successfully, you should consider the impact of investment performance, taxability, income needs, and longevity (to name a few).
A good place to start is with an annual projection that lines up income, expenses, and withdrawal needs. This projection may provide the baseline for how much you can expect to spend in retirement and how long the money will last.
Further analysis will drill into how inflation, market volatility, and lifestyle changes all impact the plan. This analysis can also consider which accounts to take money from first, what the take impact may be, and how these decisions are all impacted by required minimum distributions, Social Security, and other pension decisions.
Finally, keep in mind that each of these decisions may need to be reevaluated on a yearly basis as life changes, as tax laws change, and as investments change. The plan on day one may end up looking different than the plan in years two and beyond.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.