So much attention is focused on how to build a large retirement portfolio that retirement itself seems to get lost. It is important to determine ahead of time how much income you should withdraw during retirement, and the closer you get to retirement, the more important this consideration becomes.
Unfortunately, how much income you should withdraw is more art than science and may come down to personal preference as much as anything else.
The trick is coming up with a method that will enable you to withdraw the income you need without completely draining your savings.
Here are some suggested ways to make that happen.
The Safe Withdrawal Rate
This is undoubtedly the most widely recommended retirement income withdrawal method. The theory is you can withdraw 4 percent of your retirement plan each year and never deplete your portfolio. Of course, in order for this to work in that manner, you need to have an average rate of return substantially higher than 4 percent.
Since stocks have been returning something on the order of 10 percent per year since the 1920s, if all of your portfolio is invested in stocks, you can withdraw 4 percent per year and still increase your portfolio by 6 percent.
Advantages — If your portfolio grows by more than 4 percent per year over the long run, you will have a steady income and a portfolio that keeps growing — hopefully at least enough to cover inflation. In theory, at least, it’s the best of all worlds.
Disadvantages — This will be a losing strategy if much, most or all of your portfolio is invested in fixed-income securities paying less than 4 percent per year. You will eventually draw your retirement portfolio down to a point where the interest income is insignificant. High inflation and/or a prolonged bear market are the mortal enemies of this strategy.
As a Supplement Only
This is not a formal withdrawal method, but loosely based on the idea you take as much money out of your portfolio each year as you need to supplement other retirement income.
If you need $50,000 in retirement income, and you have Social Security and pension income of $30,000 per year, you withdraw the difference ($20,000) from your retirement portfolio each year.
Advantages — This can work extremely well if you have a very large retirement portfolio. And if you withdraw $20,000, and the portfolio earns more than $20,000 in investment income, you will always be ahead.
Disadvantages — This method won’t work with very small retirement portfolios or if your withdrawals consistently exceed your investment’s earnings. You’ll need to figure out if you can withdraw a large or small amount based on the size of your portfolio.
As Little as Possible
Some people are natural savers. No matter how much income they have, they can always live on a little bit less. Such a person may reach retirement age and live exclusively on Social Security, earned income, non-retirement portfolio income and maybe pension income.
If this sounds like you, you may never, or at least rarely ever, dip into your retirement savings.
Advantages — You’ll never go broke with this method. By minimizing withdrawals, especially early in your retirement years, your portfolio continues to grow. This ensures continued prosperity, even if other income sources eventually disappear.
Disadvantages — This method could see you living beneath your means and not enjoying your “Golden Years“ to the fullest. The sacrifice to save may have an opportunity cost of missing out on adventures.
Allocated Over Your Life Expectancy
This is basically taking your retirement portfolio and dividing it by the number of years you expect to live. If you plan to retire at 65 and expect to live to be 90, you’ll need to make your portfolio last for at least 25 years.
If you have a $500,000 retirement portfolio, you can simply divide the balance by 25 years, giving you $20,000 per year. Coincidentally, that works out to be 4 percent per year, which brings us back to the safe withdrawal rate. And again, in theory at least, your portfolio will never run dry.
Advantages — This method guarantees you will always have money from your retirement portfolio, regardless of what your investment income is doing. That is as long as the equity markets don’t take a prolonged dive.
Disadvantages — Like the safe withdrawal rate, you can deplete your portfolio more rapidly during prolonged bear markets. And of course the most obvious potential problem is the possibility you underestimate how long you will live. If you estimate 20 years and you live another 30, you could spend the last decade of your life with no retirement savings.
Withdraw Income Only – Never Touch the Principal
This method could be even safer than the safe withdrawal rate. Let’s say you have a portfolio in retirement that is 60 percent in growth-type mutual funds and 40 percent in fixed-income investments. You would withdraw only from the interest, dividends and capital gains distributions your portfolio produces.
You would never touch the actual principal portion of your portfolio, which means growth-type assets would be allowed to continue growing and increasing your portfolio size.
Advantages — This method could be the safest and most efficient of all. It enables you to draw an income each year while still allowing your portfolio to grow. And since you’re not relying on either a fixed dollar amount or a fixed percentage for the withdrawals, your portfolio will never run out.
Disadvantages — It’s more problematic in times when interest rates and dividend rates are historically low. Otherwise, it’s the perfect withdrawal method.
Required Minimum Distributions
Rather than using your retirement portfolio as a source of income, instead you rely on it only as a backstop. When you hit age 70½, you have to take Required Minimum Distributions (called RMDs), or else get penalized on the funds in your retirement plan.
You’re basically using your retirement portfolio as a giant emergency fund and withdrawing only the funds you have to in accordance with RMDs. You then rely on other income sources to provide for basic costs of living and dip into retirement savings only when you have large expenses.
This is another method that could work to preserve your portfolio for the later years of your retirement.
Advantages — This method could allow your portfolio to continue to grow throughout your retirement years, allowing you a small supplemental income with the regular distributions. You pull out additional money only as needed and hope your emergencies aren’t too frequent or too large.
Disadvantages — It won’t provide you with a steady income, and it won’t work if you’re frequently dipping into it for one emergency or another. Define what emergencies really mean and withdraw only the RMD amount.
This list isn’t complete, but you might use it as the basis of your own best strategy to withdraw money in retirement.
Do you have another strategy to add to this list? How are you withdrawing money during retirement?