Tips on Creating a Tax-Smart Withdrawal Strategy for Retirement

Tips on Creating a Tax-Smart Withdrawal Strategy for Retirement

August 05, 2020

There are many factors to consider when planning for your retirement — and one of them is how, when, and how much you will withdraw from your retirement accounts. Plus, you’ll want to determine what is the most advantageous way for you to draw down savings while minimizing taxes. 

With 76 million Baby Boomers starting to retire and reach the age of required minimum distributions (RMD), creating a sustainable retirement income distribution plan is especially crucial. The decisions you make now can make or break your retirement success.

Here are key points to consider when developing your retirement withdrawal strategy.

Questions to Ask Yourself Before Developing Your Strategy

There are several factors to consider for your retirement strategy, such as your expected health care costs, living expenses in retirement, life expectancy, savings, investments, and retirement accounts.

To find the right withdrawal strategy — and retirement strategy overall — for you, you should consider the following questions: 

When should I retire — age 62? 65? 67? 70?

  • What are my goals for retirement?
  • Where will I live?
  • What’s my life expectancy?
  • What do I expect my health care costs will be in retirement? 

What investments do I have — and should have?

  • What retirement accounts do I have — traditional or Roth IRAs or 401(k)s?
  • Should I use a QLAC (Qualified Longevity Annuity Contract)? 
  • Should I consider using home equity in retirement? 
  • What real estate do I own?
  • How should my investment portfolio be allocated in retirement?
  • What is the best use of my assets in retirement?
  • What amount of risk am I comfortable taking and what level of portfolio risk am I able to take?
  • What is a safe amount of money I can withdraw from our portfolio with little risk of running out of money?
  • What guardrails do I need to set up so that I’m not withdrawing too much? 

What will my Social Security benefits be in retirement?

  • How will I claim Social Security and pensions? 
  • What is the best time to take Social Security? 

How much do I have in savings?

  • How much retirement income will I need or want?
  • How long will my money last in my retirement?
  • What do I expect my living expenses to be in retirement?
  • How will I amass the money that I need?
  • What other sources of income aside from my investments and Social Security do I have access to (e.g., pensions, reverse mortgages, rental properties)?
  • Will I work in retirement? 
  • What strategies or part-time jobs could help with getting extra money? 

Developing Your Strategy

Michael Kitces — financial planner, speaker, and educator — said at Investments & Wealth Institute‘s 2019 annual conference that there are four simple steps to follow when creating your most tax-efficient withdrawal strategy:

Identify sources of cash flow and related costs

  • “After working 40 years where paychecks showed up in your bank account every two to four weeks, now there’s no more paychecks. How are you going to make the check, the cash, show up in your bank account every two to four weeks?” he said. It’s important to work with a financial advisor to secure your income stream and understand where and when unexpected costs may be coming to ensure you maintain your lifestyle in retirement.

Determine how to withdraw money

  • Kitces calls this account sequencing — how you’re going to manage your tax rates through your retirement to equalize the distributions from your various accounts. A financial advisor can be immensely helpful in determining the most tax-efficient ways to draw down your money (from the right accounts, in the right order).

Put the right assets in the right accounts

  • You might have three types of accounts — tax-deferred, tax-free, and taxable — and many different types of investments. Which investments do you place in which accounts? This is essential to maintaining a viable income stream in retirement.

Make annual strategy adjustments

  • A withdrawal strategy must be dynamic. “You have to monitor this on an annual basis,” Kitces said. “It’s not a set-and-forget. You still have to manage some of this on an ongoing basis because there’s essentially tax alpha opportunities every year, year by year.”

Common Retirement Withdrawal Strategies

Now that we’ve provided an overview of key considerations and best practices when preparing for retirement, let’s take a deep dive into popular tax-efficient retirement withdrawal strategies:

The 4% withdrawal rule

The 4% withdrawal rule guideline was published by retired financial planner William Bengen in 1994. The figure was promoted as a safe annual withdrawal rate after testing it on historic financial crises, including the Great Depression.

With the 4% withdrawal rule, you withdraw 4% of your retirement savings in your first year of retirement. In the following years, you tack on an additional 2% to adjust for inflation.

  • Pros: It’s simple to follow and gives you a predictable amount of income each year.
  • Cons:It has been criticized for not considering the effects of rising interest rates and market volatility. It also fails to take into account how retirees’ spending patterns can change in retirement.

Fixed-dollar withdrawals

Some retirees take out a fixed dollar amount over a specific period of time. While this provides predictable annual income which can help with budgeting, it doesn’t protect against inflation and you could erode your principal. If your investments are down in value due to market volatility, you may need to sell more of your assets to meet your withdrawal needs. 

  • Pros:It can simplify your personal money management. If you arrange a fixed-dollar withdrawal from an IRA account, federal taxes can be automatically withheld.
  • Cons:It doesn’t protect against inflation. Plus, in a down market, you may have to liquidate more assets to meet your fixed-dollar withdrawal.

Fixed-percentage withdrawals

Another approach is to withdraw a set percentage of your portfolio annually. The dollar amount of the distribution will vary, based on the underlying value of your portfolio. While this method creates a certain amount of uncertainty, if you choose a percentage below the anticipated rate of return, you could grow your income and account value. But if the percentage is too high, you could deplete your assets prematurely.

  • Pros:It is a simple formula to follow.
  • Cons:The 4% you decide to withdraw will not equal the same amount each year. The pool of money you’re drawing from will grow or shrink annually, so you will not get a consistent annual income.

Systematic withdrawal plans

In a systematic withdrawal plan, you only withdraw the income, such as dividends or interest, created by the underlying investments in your portfolio.

  • Pros:It only touches the income — not your principal — so your portfolio maintains the potential to grow.
  • Cons:You won’t withdraw the same amount of money every year, and you might get outpaced by inflation.

Withdrawal “buckets” strategy

With the “buckets” strategy, you divvy up your savings into separate account types based on your goals. It could be as simple as three buckets: emergency savings, living expenses, and long-term savings. You withdraw assets from the three “buckets,” or separate types of accounts holding your assets. 

The first bucket should hold about 20% of your savings — about three to five years of living expenses — in cash. The second bucket holds mostly fixed income securities. The third bucket contains your remaining investments in equities. As you use the cash from the first bucket, you replenish it with earnings from the second and third buckets.

  • Pros:It allows your savings to continue to grow over time. Through constant review of your funding, you also benefit from a sense of control over your assets. It also reduces your exposure to investment risk because you don’t have to sell stocks when the market is down. You’ve got cash on hand to pay your expenses, which can protect your savings over the long run.
  • Cons:This approach is more time-consuming. And you still need a withdrawal strategy for your invested savings. 

Talk to an Experienced Financial Advisor Today

Every person has unique goals and needs, so your retirement plan needs to be tailored to your specific situation. For long-term financial security, don’t tap into your retirement savings without a plan.

Because every retirement is different, you should talk to a financial advisor about your plans for retirement and develop a strategy. An advisor will help you determine how much you need to save and how much you can spend each year to avoid running out of money. If you’re looking for a trusted, experienced financial advisor to evaluate your situation and develop the best retirement withdrawal strategy for you, reach out to us today.