David Lerner Associates: Making Portfolio Withdrawals
When planning for retirement income, you'll need to determine your portfolio withdrawal rate, decide which retirement accounts to tap first, and consider the impact of required minimum distributions.
Your retirement lifestyle will depend not only on your asset allocation and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from returns or the principal itself, is known as your withdrawal rate.
Take out too much too soon, and you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could. Your withdrawal rate is especially important in the early years of your retirement; how your portfolio is structured then and how much you take out can have a significant impact on how long your savings will last.
What's the right number? It depends on your overall asset allocation, projected inflation rate and market performance, as well as countless other factors, including the time frame that you want to plan for. For many, though, there's a basic assumption that an appropriate withdrawal rate falls in the 4% to 5% range. In other words, you're withdrawing just a small percentage of your investment portfolio each year. To understand why withdrawal rates generally aren't higher, it's essential to think about how inflation can affect your retirement income.
Consider the following example: Ignoring taxes for the sake of simplicity, if a $1 million portfolio earns 5% each year, it provides $50,000 of annual income. But if annual inflation pushes prices up by 3%, more income--$51,500--would be needed the following year to preserve purchasing power. Since the account provides only $50,000 income, an additional $1,500 must be withdrawn from the principal to meet expenses. That principal reduction, in turn, reduces the portfolio's ability to produce income the following year. As this process continues, principal reductions accelerate, ultimately resulting in a zero portfolio balance after 25 to 27 years, depending on the timing of the withdrawals.
When setting an initial withdrawal rate, it's important to take a portfolio's potential ups and downs into account--and the need for a relatively predictable income stream in retirement isn't the only reason. If it becomes necessary during market downturns to sell some securities in order to continue to meet a fixed withdrawal rate, selling at an inopportune time could affect a portfolio's ability to generate future income. Also, making your portfolio either more aggressive or more conservative will affect its lifespan. A more aggressive portfolio may produce higher returns, but might also be subject to a higher degree of loss. A more conservative portfolio might produce steadier returns at a lower rate, but could lose purchasing power to inflation.
The higher your withdrawal rate, the more you'll have to consider whether it is sustainable over the long term.
Tapping tax-advantaged accounts--first or last?
You may have assets in accounts that are tax deferred (e.g., traditional IRAs) and tax free (e.g., Roth IRAs), as well as taxable accounts. Given a choice, which type of account should you withdraw from first?
If you don't care about leaving an estate to beneficiaries, consider withdrawing money from taxable accounts first, then tax-deferred accounts, and lastly, any tax-free accounts. The idea is that, by using your tax-favored accounts last, and avoiding taxes as long as possible, you'll keep more of your retirement dollars working for you on a tax-deferred basis.
If you're concerned about leaving assets to beneficiaries, however, the analysis is a little more complicated. You'll need to coordinate your retirement planning with your estate plan. For example, if you have appreciated or rapidly appreciating assets, it may make sense for you to withdraw those assets from your tax-deferred and tax-free accounts first. The reason? These accounts will not receive a step-up in basis at your death, as many of your other assets will.
But this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may make sense to withdraw from taxable accounts first. This is because your spouse is given preferential tax treatment when it comes to your retirement plan. Your surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan, or, in some cases, may continue the plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until after your spouse reaches age 70½. The bottom line is that this decision is also a complicated one, and needs to be looked at closely.
Required minimum distributions (RMDs)
In practice, your choice of which assets to draw on first may, to some extent, be directed by tax rules. You can't keep your money in tax-deferred retirement accounts forever. The law requires you to start taking distributions--called "required minimum distributions" or RMDs--from traditional IRAs by April 1 of the year following the year you turn age 70½, whether you need the money or not. For employer plans, RMDs must begin by April 1 of the year following the year you turn 70½, or, if later, the year you retire. Roth IRAs aren't subject to the lifetime RMD rules.
If you have more than one IRA, a required distribution amount is calculated separately for each IRA. These amounts are then added together to determine your total RMD for the year. You can withdraw your RMD from any one or more of your IRAs. (Similar rules apply to Section 403(b) accounts.) Your traditional IRA trustee or custodian must tell you how much you're required to take out each year, or offer to calculate it for you. For employer retirement plans, your plan will calculate the RMD, and distribute it to you. (If you participate in more than one employer plan, your RMD will be determined separately for each plan.)
RMDs are calculated by dividing your traditional IRA or retirement plan account balance by a life expectancy factor specified in IRS tables. Your account balance is usually calculated as of December 31 of the year preceding the calendar year for which the distribution is required to be made.
It's very important to take RMDs into account when contemplating how you'll withdraw money from your savings. Why? If you withdraw less than your RMD, you will pay a penalty tax equal to 50% of the amount you failed to withdraw. The good news: You can always withdraw more than your RMD amount.
Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable-- we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
Some of this material has been provided by Broadridge Investor Communications Solutions, Inc.
David Lerner Associates does not provide tax or legal advice. The information presented here is not specific to any individual's personal circumstances.
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Founded in 1976, David Lerner Associates is a privately-held broker/dealer with headquarters in Syosset, New York and branch offices in Westport, CT; Boca Raton, FL; Teaneck and Princeton, NJ; and White Plains, NY. For more information contact David Lerner Associates Call 516-921-4200 Visit our website: http://www.davidlerner.com