So it’s time to withdraw from your tax-protected retirement stash, usually an IRA. According to a new law, when you reach 72, you have to take out at least the amount that’s calculated under actuarial tables, using your expected lifespan.
This move is called a required minimum withdrawal, or RMD. Those who turned 70½ last year are governed by an earlier law and must start taking the RMD, although they can delay withdrawing until this coming April 1.
But there’s some flexibility in how you take RMD money out. The overall objective, of course, is to make the funds last a lifetime. Nobody wants to be 95 and penniless.
You typically pay ordinary income rates on what you take out. To be sure, to avoid that, you can put your investments into Roth vehicles before retirement, where you pay taxes up front instead of when you’re retired. You have to do the math to see what works best for you.
Beyond this, the three most-used alternatives are a 4% withdrawal rate, a fixed rate and the buckets. All in all, the buckets approach is the wisest. Let’s look at them:
4% Withdrawal
There is a general (albeit not unanimous) agreement among advisors that this approach gives you the best chance of not running out of money in retirement and having sufficient income to pay your bills. Plus, it’s not hard to administer. Here, you withdraw 4% of your holdings every year. The only additional math is to adjust the amount annually to inflation.
Example: You have a $1 million retirement account. The first year, you withdraw $40,000. After that, you remove a little more, taking inflation into account. Say inflation is 1.5%. You plus up the original $40,000 to $40,600. That extra $600 is 1.5% of $40,000. And so forth.
Most recently, inflation bumped up to 2.5%, but many see that as abnormal. Another danger is that a bear market can slam your stock holdings, so you will need to withdraw more than you bargained for.
Fixed Dollar Strategy
This one is the most simple. You extract a fixed amount per year, maybe a flat $40,000. After three years, you take a look at your situation and decide if you need to increase the withdrawal. Even though the most recent inflation sounding was a 2.5% increase over 12 months, see if your costs went up that much. Odds are they didn’t.
The Bucket Plan
You divvy your retirement assets into three separate accounts, which financial advisors call buckets. This lets you to set side a chunk of your investments to grow, while having the assurance of a steady income stream.
To many advisors, this approach combines both safety and a sense of control for you. The bucket stratagem can be a hassle, however, as you must continually keep track of where you are placing your money.
The first bucket is in cash, which is put into bank savings accounts or money market mutual funds. Nowadays, these vehicles tend to at least track inflation in terms of interest payouts. The point is to re-fill the cash bucket with what the other two buckets earn. You want to have three years or so worth on cash in this bucket.
So you take out income from this bucket every year. This allows your savings to keep on growing over time, a comfort if you are afraid of running out.
The second bucket is for fixed-income assets, meaning bonds or bond mutual funds. These can do better on interest income than cash does. Depending on the type of bonds (junk pays higher, and of course is riskier than Treasurys or corporate investment grade bonds) you can earn from 3% to 5%.
Bucket number three contains stocks. This one is where you expect the most growth—and historically that is true aside from the occasional market slump—as equities rise much more often than the fall. The S&P 500 finished up almost 30% in 2019. While such scorching appreciation is extraordinary, the long-term average growth rate after inflation of stocks is 7%. Not bad.
You channel the interest, dividends and price appreciation, or as much of it as you need, to your cash bucket. And then you live off it.