Building a fiscal foundation during your 20s and 30s; and accumulating wealth as you enter into your forties are the first two stages respectively of a multi-stage effort for securing a financially sound retirement.
The third stage is pre-retirement, the five-year period prior to your desired retirement age. During this period, there are two elements to consider:
- The complete elimination of debt
- Developing a plan to draw-down the retirement nest egg
Up to this point, eliminating debt was a goal. However, now that you are close to leaving the workforce, it is absolutely essential to be debt-free as debt, along with taxes, is an impediment to maintaining fiscal fitness in retirement. As debt is reduced, attention should be turned to developing a plan for drawing down the nest-egg. Too many retirees jeopardize their retirement by drawing down their nest-egg too fast and in an inefficient order.
Regarding the withdrawal rate, a popular method is the 4% rule …
In general, the rule – developed by William Bengen – says that if a retiree takes out 4% of their nest-egg the first year in retirement, and then adjusts that rate to account for inflation in each subsequent year (e.g. if inflation rises 1% during the first year of retirement, 5% would be taken out during the second year in retirement), they will not run out of money for at least three decades.
The number is based on a portfolio with a 60/40 split between large-cap stocks and intermediate-term government bonds. After continued research Mr. Bengen added small-cap stocks to the mix and revised the ‘rule’ to 4.5 percent. However, the 4% name has stuck over the years. While some believe it is simply too arbitrary, some believe it is too high, and some believe too low, it provides a good starting point for most people. Determining the withdrawal rate, whether it be the popular 4% rule, or others such as the interest only strategy, must be accomplished prior to retirement.
Determining the order of withdrawal from the various retirement accounts is also critical prior to retirement. For example, if the retiree is 70½ years of age, the general rule of thumb is to first withdraw from accounts where Required Minimum Distributions (RMDs) are mandated. However, for most retirees, the order of withdrawal, before they reach 70½ years of age and are subjected to RMDs, will be from taxable accounts (e.g. brokerage cash account), then tax-deferred accounts (e.g. 401[k]), and finally tax exempt accounts (e.g. Roth IRA).
Taxable accounts are withdrawn first as they are generally taxed at favorable dividend and capital gains rates, and only on the capital appreciation. If the expectation is that future tax rates will be higher than current rates, it makes sense to withdraw from tax-deferred accounts next. However, if the expectation is that the future tax rate will be lower than the current, retirees should spend from tax exempt accounts prior to tax-deferred accounts.
The last thing you want, with regards to finances, is to come up short halfway through retirement. Eliminate debt before retiring and develop a savvy withdrawal plan that considers the rate and order of withdrawal from your various retirement accounts.
How about your withdrawal plan, SavvyReader? Does it consider your debt load at the time of retirement, taxes, the different types of accounts, the withdrawal rate, your retirement age and the number of years spent in retirement?