After many years of saving and investing money for retirement, this may very well be a question you never bothered to ask yourself. After all, the basic purpose of retirement planning is accumulating a sufficient amount of money so retirement can happen in the first place. You may think the question, “How should you spend your assets during retirement?” may be irrelevant until you actually retire.
But it’s not. One of your biggest concerns as you approach retirement is making sure your investments — particularly your retirement portfolio — last for the rest of your life.
For this reason alone, spending decisions have to be considered.
Avoid Touching the Principal Balance
This is the best way to make your money last the rest of your life. You should restrict withdrawals from your retirement portfolio to no more than the income earned within the portfolio. The principal should remain untouched so it will be available to earn additional income in the future.
Since a person retiring at age 65 is very likely to live for at least an additional 20 years or longer, it would be ideal if you could avoid tapping the principal for at least the first 10 years of your retirement.
If you can withdraw less than the full amount of the income earned on your portfolio, this would be even better. Retaining at least some income in the portfolio and using it to increase the size of your portfolio will help your investments keep pace with inflation.
Just as is the case throughout your life, you’ll have to balance current needs with future requirements. There are of course a few exceptions with regards to withdrawing principal.
Pay Off Your Mortgage
Owning a home free and clear is one of the very best preparations for retirement. It lowers what is probably your largest single monthly expense, your house payment. If you have been unable to pay off your mortgage by the time you retire, withdrawing money from your retirement account might make a lot of sense.
Paying off your mortgage may even provide a better return on your money than a comparable amount invested in stocks.
Let’s say you took a $200,000 mortgage at 6 percent interest 20 years ago and you still owe $100,000 on it with 10 years remaining. Your current payment, not including taxes and insurance, is $1,200 per month or $14,400 per year.
If you withdraw $100,000 from your retirement savings to pay off the mortgage, it will be the equivalent of earning $14,400 per year as a result of not having a mortgage payment. This is equal to a 14.4 percent return on your money ($14,400 divided by $100,000).
We haven’t accounted for the tax bite on the withdrawal from your retirement accounts if you withdraw before retirement age, and the numbers used are rounded. But this is just an example, and the specifics will be different in each case.
Major Emergencies Only
It should go without saying that any major emergency is a good reason to spend your retirement assets. This would certainly include funds needed for medical emergencies and major procedures, or even the occasional need to help out an adult child.
Be very careful to keep your list of acceptable emergencies as short as possible. You certainly don’t want to be raiding your retirement accounts for relatively ordinary events, like major car repairs or replacing the furnace in your home. You should already have an emergency fund set up for these expenses.
The “Safe Withdrawal Rate”
This is a very general rule of thumb to be used as a default option if you aren’t exactly sure how to spend your assets in retirement.
The safe withdrawal rate — which is 4 percent of your portfolio value — is the percentage at which you should be able to withdraw money without ever depleting your portfolio to dangerous levels. It’s mostly a theory, though it actually makes sense.
Let’s say starting at 65 (or whatever age you retire) you are earning the historical average rate of return of 8 percent on your stock portfolio. If you withdraw 4 percent per year for living expenses, this will leave the remaining 4 percent in the account so your portfolio will continue to grow. This allows you to live your life while keeping your portfolio healthy and growing.
Obviously, there are some flaws with this theory. Stocks don’t consistently return 8 percent each and every year. In years or sequences of years when stocks decline, withdrawing 4 percent will only accelerate the decline in the value of your portfolio.
In addition, by the time you reach retirement age, the percentage of your portfolio invested in stocks will likely be much lower than it is right now, lowering your overall rate of return to something less than 8 percent per year.
Required Minimum Distributions, or RMDs
If you aren’t exactly sure how you will spend your assets in retirement, the IRS will have the solution to your problem — eventually.
One of the lesser-known IRS provisions regarding tax-deferred retirement plans is you are not allowed to continue accumulating them forever. Not only are you required to stop funding IRAs, 401(k)s and other plans by age 70, but you’re also required to begin making withdrawals no later than age 70½. This provision is referred to as required minimum distributions, or RMDs.
The IRS has a formula you must use to determine how much you must begin withdrawing after age 70½. Alternatively, you can use a required minimum distributions calculator to help you determine what this number is at any given age. For example, if you are 71 years old and have a retirement portfolio of $500,000, you will be required to withdraw a minimum of $18,868 during the year.
This works out to be 3.92 percent of your portfolio, which is curiously close to the 4 percent safe withdrawal rate. But don’t lock into this percentage; it will increase each year thereafter.
Even if you are nowhere near retirement age, you might still consider some of the options above. Ultimately, the reason you are saving money for retirement is so you can spend it when the time comes.
How much of this you will spend at any given time and what you’ll spend it on can have a major impact on your retirement overall.