Retirement plans

Retirement plans

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Where will your retirement income come from?
Make withdrawals without running out of money
How to handle a retirement income shortfall

Make withdrawals without running out of money

The key question about withdrawing from your retirement plan or IRA is "How much?" How much can you withdraw each year while making sure your money lasts as long as you do?

The 4% rule

If you want your savings to last for 30 years or more, consider withdrawing no more than 4% of your balance in the first year of retirement. After the first year, you might choose to increase your annual withdrawal by the rate of inflation. That way your spending power should have a good chance of keeping up with the rising cost of living.

The 4% rule applies even if you use part of your retirement savings to purchase an annuity. Simply apply the rule to the remaining balance in your retirement plan or IRA.

For example

Maria's balance in her 401(k) plan is $100,000 when she retires. During the first year of retirement, she withdraws 4% of her balance, or $4,000.

Inflation runs at 2.5% over the course of that year. When year two of retirement begins, Maria adjusts her withdrawal amount by the rate of inflation and withdraws $4,100.

But be flexible too. If a sharp market decline reduces the value of your portfolio (say, by 10% or more), consider tightening your belt. You might skip inflation increases for a year or two, for example, or even reduce your withdrawal amount. This might help to prolong your retirement savings, although there are no guarantees.

For example

At the beginning of Maria's third year of retirement, a sharp downturn in the market reduces her 401(k) balance to $80,000. She adjusts her withdrawal amount to 4% of her reduced balance, which comes to $3,200.

Investing for 4% withdrawals

Retirees who undertake a systematic withdrawal plan like this should consider keeping some of their savings in a diversified mix of stocks and bonds. Stocks do have sharp price swings. But, compared with bonds and short-term reserves, they have also shown greater potential for long-term growth, which may help to sustain your savings over a lengthy retirement. Just keep in mind that whenever you invest, there’s a chance you could lose the money. Bond funds are made up of IOUs, primarily from companies or governments. These funds risk losing value if the debt isn’t repaid on time. Also, bond prices can drop when interest rates rise or the issuer’s reputation suffers. Diversifying means having different types of investments. It doesn't guarantee you'll make a profit or that you won't lose money.

Take your withdrawals in a tax-efficient order

Unfortunately, you never get to retire from taxes. If you've saved pre-tax dollars in a retirement plan or IRA, the bill comes due after you retire. When you withdraw pre-tax contributions and earnings, you owe ordinary income taxes on that money.

If you have different types of accounts, you may be able to prolong your tax savings by withdrawing your money in a tax-efficient order:

  • Withdraw from any taxable accounts before touching your tax-advantaged accounts.
  • Consider withdrawing money from tax-deferred accounts, such as an employer's plan or a traditional IRA.
  • Withdraw money from tax-free accounts, such as qualifying Roth contributions to an IRA or employer's plan.

Consider setting aside a portion of each withdrawal to meet your income tax obligation. If you're withdrawing from an employer's plan, most plan providers are required to withhold 20% of each withdrawal for federal taxes, though your actual tax bill may be higher or lower.

Create a cash reserve

You might think of your retirement savings as divided into two broad categories:

  • Long-term money, which remains invested in the markets (for example, in stock and bond mutual funds) to capture earnings and growth opportunities.
  • A cash reserve, your spending money for the next year or two. A low-cost money market fund can be a smart investment choice for your reserve. Your goal should be to protect the money you need for short-term expenses from the possibility of market declines.

Deriving income from your retirement savings is a process of gradually transferring money from your long-term investments to a short-term spending account. You can move the amount you expect to need for 12 months into your money market fund at one time. That way you won't have to worry that market swings will affect your immediate spending needs.

For convenience, you can link your money market fund electronically to your bank account, so you can easily move money to your checking or debit accounts. You could also set up automatic monthly transfers to your checking account to recreate the cash flow of a regular monthly paycheck.

Some withdrawals are required

When you reach a certain age, you must take required minimum distributions (RMDs) from tax-deferred retirement savings unless you are still working. If you do not withdraw the required amount each year, you could owe a large penalty tax on that amount. Plus, you will still need to withdraw the required amount and pay your ordinary taxes on it.

The IRS requires that you begin taking distributions at age 72.

After you reach the age for RMDs, Vanguard can calculate RMDs for your Vanguard IRA® and any accounts in retirement plans that offer the service. If your money is in a Vanguard IRA, call 800-205-6189 to have Vanguard send your RMDs to you automatically. If you've kept your money in your employer's retirement plan, call us at 800-523-1188.

Action steps

  • Estimate the balance from which you will be withdrawing variable income.
  • Plan to withdraw no more than 4% of this balance in year one of retirement.
  • Decide where to deposit your withdrawals.
  • Schedule a day each year to adjust your withdrawal amount by the rate of inflation.
  • Reset your withdrawal amount if there is a large market downturn.