If you’re like me, you hope that working hard and saving diligently throughout your life will result in a healthy nest egg that you can live off of in retirement. You’ve tried to make the right choices when it comes to retirement accounts, specific investments, and asset allocation. But how can you make sure that the money in your nest egg doesn’t run out during retirement? You need a proper safe withdrawal rate.
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Defining Safe Withdrawal Rates
Before you can learn about strategies for safe withdrawal rates in retirement, you need to know what that means. A safe withdrawal rate during your retirement years is an amount you can withdraw every year from your retirement accounts without running out of money during retirement. You might expect this to be a guaranteed rate you can withdraw and never run out of cash. That isn’t the case. A safe withdrawal rate is one that gives you a reasonable expectation of not running out of cash — but there is no guaranteed rate (other than 0%!) that will make sure you never run out of retirement income.
Consider Life Expectancy
To determine your withdrawal rate you need to consider your expected life expectancy. It isn’t necessarily fun to consider how long you think you will live, but it is a critical aspect of retirement planning. If you don’t expect to live as long and build your portfolio with that in mind, but you end up living longer than expected, you can easily run out of cash. Consider family history, your medical history, and your current health. It probably makes sense to ere on the side of caution (living longer) than to blow your portfolio in the first five years of retirement.
Asset Allocation and Retirement Withdrawals
In conjunction with your life expectancy strategy you will need to consider your asset allocation. The higher percentage of your portfolio you put into stocks, the higher returns you can expect. However, you can also expect much greater volatility in stocks than in fixed-income investments such as bonds. If you can afford a lower withdrawal rate over your retirement, it makes sense to put a larger percentage of your portfolio into fixed-income investments. This will smooth out the ups and downs of the stock market while still providing you the income you need. Likewise, if you want a higher withdrawal rate you must accept some risks by mixing in more volatile stock investments into your retirement plan.
Required Minimum Distributions
An often overlooked aspect of determining your safe withdrawal rate is which retirement accounts you will be pulling your retirement income from. Some retirement accounts require you to begin taking minimum distributions from the account at age 70 and 1/2. As you are planning out where to withdraw money from, it makes sense to tap these accounts last if you can afford to. Additionally you must consider if you have tax-advantaged accounts (such as a 401k, 403b, or Traditional IRA), you need to be careful in limiting the tax you pay on the income you withdraw. If you are withdrawing solely from Roth IRAs or Roth 401ks, then you have already paid tax and don’t need to worry about paying additional income tax on your withdrawals.
Retirement Withdrawal Strategies
So how do you determine the right withdrawal strategy for your retirement? There isn’t a single rule of thumb that will fit every situation. Your safe withdrawal rate will be determined by the above factors; however, there are a few common methods to determining your withdrawal rate:
The 4% Rule
One of the most common strategy for a safe withdrawal rate is the 4% rule. Simply put, this rule lets you pull out 4% of your starting retirement portfolio every year. If you had a $1,000,000 nest egg, you could withdraw $40,000 every year. If your portfolio didn’t change at all, this would mean you could withdraw $40,000 for 25 years.
Adjust Based on Performance
A second strategy is to adjust your withdrawals based on the performance of your portfolio. You could start out at 4% withdrawals, but if you experienced a big hit to your portfolio (like many did a few years ago), you would ramp down your withdrawals so your portfolio has time to recover. Likewise if your portfolio experiences a huge gain in the first few years of retirement, you could up your withdrawals a bit so you can enjoy the extra income while your health is still good.
One way to accomplish this is to withdraw a fixed percentage of your portfolio each year (instead of a fixed amount like $40,000). For example, if your fixed percentage is 4% and you start out with $1 million, you would withdraw $40,000 the first year. Let’s assume your portfolio goes up to $1.1 million the second year, you would withdraw $44,000 that year. And on the 3rd year, your porfolio goes down to $950,000, so you would only withdraw $38,000.
Adjust for Inflation
A third strategy that is essential in almost any method of withdrawing retirement income is to adjust your withdrawals for inflation. In our 4% example you could withdraw $40,000 per year for 25 years if your portfolio never changes (e.g. if you were 100% in cash). However, $40,000 today is worth a lot more than $40,000 25 years from now. Inflation will dig into the value of your withdrawal so that you would need to withdraw $81,311 in Year 25 to have the same level of income (assuming constant 3% inflation). That’s why you can’t sit your portfolio into 100% cash once you hit retirement. You still need your portfolio to grow at least at the pace of inflation just so your retirement income doesn’t take a hit over time.
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.