Three Strategies for Transitioning From Saving to Spending in Retirement
After decades of saving for retirement, you’re finally approaching the finish line and getting ready to transition into the next chapter of life. Congratulations! You have a lot to look forward to in your retirement years. Yet, making the shift from saving to spending in retirement can be difficult. So, what’s the best way to turn your retirement savings into retirement income? Like most aspects of financial planning, the answer depends on your personal financial situation and goals for the future. Here are three strategies often used by retirees to convert their savings into a monthly income during retirement.
Strategy #1 – A dividend strategy
A dividend strategy involves building a portfolio where the average dividend is enough to satisfy your income need each year. However, in this historically low interest rate environment, a dividend strategy for taking income is often a tough one to embrace. Currently, a broadly diversified portfolio is unlikely to deliver much more than about 2% per year in dividend income. If you’re fortunate enough to need less than that each year, this strategy is an easy choice. However, when someone needs more than the dividends provided by a diversified portfolio, they are often tempted to try to find investments that pay higher dividends. This act of yield chasing often leads to a portfolio that’s heavily overweighted in slower-growing sectors, like telecom, utilities and consumer staples. While these sectors do provide larger dividends, they typically don’t provide the price appreciation over time that would help your income keep up with inflation. If you’re attracted to this strategy, it’s important to speak to a financial advisor who can help you build a portfolio that not only focuses on the dividend payers but also the dividend growers, which will give you a much better chance of keeping up with inflation. In this interest rate environment, it may also be appropriate to consider alternative investments, like a private lending fund or a private real estate income fund, to provide a stronger yield and better risk-adjusted returns.
Strategy #2 – A systemic withdrawal plan
A systematic withdrawal plan is simply a scheduled withdrawal from your investable assets based on a reasonable withdrawal rate. Retirees in their mid-sixties will typically begin by withdrawing no more than 4% of their retirement savings their first year and adjusting that dollar amount for inflation each year after that to maintain their spending power. Of course, the exact withdrawal percentage to begin with should depend on how much you have, your lifestyle goals, your life expectancy, your desires for passing on a legacy, etc. The key to this approach is maintaining a diversified investment portfolio. While stocks are typically more volatile than bonds, they provide the potential for growth within your portfolio, which is important in helping you keep up with inflation. On the flip side, an allocation to bonds or other conservative investments can help protect your nest egg during periods of volatility. In order to extend the longevity of your portfolio, it’s critical to take from stocks when the markets are up and from bonds when the markets are down. We recommend having your short- and intermediate-term needs (usually five to seven years of expenses) protected by safer investments. This way, when the markets are down, you have the ability to withdraw from less volatile investments that are up — or at least holding their ground — while you wait for the stock markets to recover. Once the markets are back and have moved on to all-new highs, it’s time to take profits from stocks and replenish the bond portfolio for the next bear market. The secret to investing is buy low/sell high, and it’s as important as ever to maintain that discipline while taking withdrawals from a portfolio.
Strategy #3 – A tax-effective withdrawal plan
If you have your retirement assets spread across multiple account types (IRAs, 401(k)s, Roth IRAs, taxable accounts, etc.), you may have the ability to optimize your retirement income by considering the tax-effectiveness of your withdrawals from each account over time.
- Taxable (non-retirement) accounts – These accounts offer the benefit of lower dividend and capital gains tax rates as needed.
- Tax-deferred retirement accounts, such as IRAs and 401(k)s – While allowing for tax-deferred growth, these accounts force ordinary income tax consequences whenever funds are withdrawn.
- Tax-exempt accounts, such as Roth IRAs – These accounts allow investments to grow tax-free for as long as possible, and qualified withdrawals are tax free.
As you structure your tax-efficient withdrawal strategy, it’s important to consider not only your different account types but also the tax brackets you expect to be in over time. Many retirees start retirement in lower tax brackets, but after being forced to take required minimum distributions (RMDs) at age 72, they discover they will likely never see those lower tax brackets again. When you include the standard deduction for joint filers, income under $100,000 or so would be in the 12% federal income tax bracket and the 0% long-term capital gains tax bracket. If you have a concentrated stock position that you would rather not carry, you may want to start your withdrawal strategy by unwinding that stock in the 0% long-term capital gains tax bracket. However, if you are happy with your taxable account investments but expect required distributions that will eventually force you into much higher tax brackets (22%, 24%, 32%, 35% or 37%), it may make more sense to go ahead and begin distributions from an IRA to the extent that you can exit in the lower 12% federal income tax bracket each year. Following this same line of thought, Roth conversions could also be a helpful consideration in the lower tax brackets, as long as you have enough in your taxable accounts to cover your expenses and pay the tax bill caused by the conversion. These types of strategic withdrawals, or conversions, from an IRA have the potential to reduce RMDs down the road. It may also be important to consider how your withdrawal strategy will eventually impact your beneficiaries. Taxable accounts receive a step-up in cost basis on your passing (meaning potentially no tax consequences for your beneficiaries), but tax-deferred retirement accounts will eventually force a total withdrawal within 10 years of your passing (accelerating and potentially increasing the tax consequences for your non-spousal beneficiaries). Keeping this in mind, strategic withdrawals from your IRA accounts have the potential to be even more beneficial as you consider passing assets to the next generation in the most tax-effective way possible. However, if your beneficiaries are charities, you may want to take the opposite approach and let your IRA-type accounts continue to defer, as qualified charities can inherit your tax-deferred retirement accounts with no tax consequences whatsoever. This would also make RMDs less of an issue, as you would be allowed to satisfy them with qualified charitable distributions (QCDs). It’s important to note that you don’t have to choose between these three strategies. We believe a retirement income plan is at its best when it incorporates all of these strategies:
- Building a portfolio that increases dividend yield without sacrificing diversification and inflation protection
- Customizing a systematic withdrawal plan with the flexibility to take from stocks when the market is up and from bonds when the market is down (extending the longevity of a portfolio beyond the capabilities of models and lifecycle funds that are forced to draw proportionally from each asset class, even when the market is down)
- Creating a tax-efficient withdrawal plan that’s tailor-made for your specific situation, your tax brackets, your required distributions, your charitable inclinations and your goals for passing wealth to the next generation (meaning you’ll leave less to the government and more to the people you care about)
As with all major financial decisions (especially those with so many moving parts), it’s important to consult with a fiduciary wealth manager before implementing any retirement income strategies. If you’d like help transitioning from saving to spending in retirement, or with any other financial matter, please schedule a call with a member of our team.
