Picture this: You worked hard your entire life, saving diligently for retirement. At 65, you were living the dream. At 75, you enjoyed a comfortable — if not luxurious — lifestyle. But at age 85, you seemed to inexplicably run out of money.
How did the ship sink so quickly? There was an iceberg, barely visible above the water but monstrous beneath the surface, as a result of mismanaged distributions and ill-conceived budgeting.
Most investors find it difficult to convert their account balances to an income stream once in retirement. The goal is to make sure you don’t outlive your assets, but how? Just as a poor distribution strategy — or none at all — can be a disaster waiting to happen, a good distribution strategy can help illuminate a better path through retirement.
Consider these tips when developing your own plan so you don’t spend too much or too little in retirement:
1. Consider the three phases of retirement.
Financial habits evolve over time. While you may have calculated the longevity of your nest egg in terms of annual retirement income, what you will be spending immediately after leaving the working world will likely be very different as you move further into retirement.
The average retiree can expect three phases of retirement:
- Early retirement. A period of travel, hobbies and adventure.
- Middle retirement. A stage marked by socializing, activity and relaxation.
- Later retirement. A time of winding down, when most of your days are spent at home.
It’s logical to assume the costs of retirement will vary among phases. Spending habits at age 50 are definitely not the same as they were at 25. Likewise, your spending at age 85 will look different than age 65. Therefore, a distribution strategy that includes specific “buckets” of money for each phase allows for more flexibility and helps ensure you won’t outlive your nest egg.
2. Nail down a plan for Social Security.
Optimizing Social Security and other guaranteed sources of retirement income, such as pensions, is hugely important so that you’re able to withdraw as little as possible from your other retirement accounts.
There are two logical approaches: You could aim to start collecting Social Security benefits as soon as you are able, which would lessen the need to draw from your other sources of retirement income — like Individual Retirement Accounts (IRAs) or a 401(k) — in your early retirement years. Or, you could delay Social Security in order to secure a higher monthly benefit, making Social Security a more important source of income later in life.
What’s right for you depends on various factors, including your income needs and estimated life expectancy.
3. Decide when to be taxed.
Tax treatment of your distributions will differ based on account type. Withdrawals from traditional IRAs, traditional 401(k)s, and brokerage accounts are taxable when distributed. For Roth IRAs and Roth 401(k)s, withdrawals and earnings are tax- and penalty-free if it’s been at least five years since you first funded the account and if one of the following conditions applies:
- you’ve reached age 59½.
- you’ve become disabled.
- your beneficiary receives the distribution upon your death.
- you’re making a qualified first-time home purchase.
Your distribution strategy should outline which accounts you will draw from first, especially if you have both traditional and Roth monies at your disposal.
You might consider consulting a tax professional prior to making these decisions. Your investment advisor should work in concert with your CPA (certified public accountant) to determine a withdrawal strategy that makes the most sense, tax-wise.
4. Plan ahead for Required Minimum Distributions.
A Required Minimum Distribution (RMD) is the minimum amount anyone over the age of 70½ is required to withdraw annually from their retirement accounts. For 401(k)s and 403(b)s, RMDs can sometimes be delayed until you retire, depending on plan rules. For traditional IRAs, you must begin taking RMDs once you turn 70½ regardless of whether you are still working. However, RMD rules do not apply to Roth IRAs while the original account owner is alive — they come into play with inherited Roth IRAs.
Your plan custodian or administrator can usually help calculate your RMD, but it’s ultimately up to you to ensure that you withdraw the correct amount each year by the deadline (typically Dec. 31)1 so as to avoid stiff IRS penalties.
These are big and complicated decisions, and what we’ve touched on here is just the beginning. But don’t worry — Financial Engines can help you make the right choices. For example, our patented Financial Engines’ Retirement Paycheck® service provides you with steady income while also allowing you to participate in the growth of the market. It offers several advantages compared to other retirement income strategies.
Contact your local advisor today for more information on how to plan for and provide a monthly retirement income.