Asset Withdrawals in Retirement: Optimal Strategies
What is the optimal withdrawal strategy for Retirement Income Portfolios? You have your portfolio, sure—your stocks and your bonds. But what else can provide the income you need in retirement? So what is your retirement strategy for asset withdrawals? And how does that help mitigate the known risks in retirement?
Which asset should you access (and when) to reduce taxes and improve overall retirement security?
This is important as we all have different sources of retirement income and different products to consider. For example, most of us have social security, pre-tax retirement plans, and home equity, while fewer have pensions or annuities.
Let’s look at withdrawal strategies in retirement designed to minimize taxes and maximize income and then discuss some features of various assets that affect how you manage your retirement withdrawals.
Asset Withdrawal Plan in Retirement
Please note that no 4% withdrawal begins at retirement and increases over time at the rate of inflation. That is not how asset withdrawal strategies in retirement works!
Retirement income is lumpy! You have different assets you access at different times with various distribution schedules. For example, you might have a 457, then Social Security starts, then RMDs. So we all have a different mix of income sources.
In addition, of course, spending is lumpy! Expenses differ over the years. You may be able to choose when you want to make a major purchase, such as a new car, but roofs blow off and need to be replaced at a more random interval. As a retirement strategy, the 4% rule is fiction.
So, what does the asset withdrawal percentage look like if you don’t pull 4% from your portfolio?
Order of Withdrawals in Retirement
Above, you can see the withdrawal rate from this retirement withdrawal strategy. You start close to 6% and increase until social security starts at age 70.
Then it drops off with social security and gradually increases over time.
At age 80, the definitive source of retirement income (in this case, a QLAC) kicks in.
Instead of being 4% and increasing with inflation, the withdrawal percentage varies depending on when your assets hit. This is because a strategic retirement withdrawal plan considers different income sources. You have, after all, different assets in your retirement quiver.
And these assets are in different types of accounts. For example, there are brokerage accounts, pre-tax retirement accounts, and after-tax Roth accounts.
So, which account do you take your income from?
Optimal Withdrawal Sequencing: Account Selection
In general, the retirement strategy for withdrawal sequencing follows a staged approach. Most commonly, you spend first from a brokerage account and then tax-deferred money. Then, finally, utilize tax-free (Roth) assets.
This sequence is an optimal retirement strategy as it allows tax-sheltered accounts to grow while spending down the taxable accounts. Spending taxable money first decreases taxes (via less tax drag) because as you spend it down, there is less to tax!
However, and importantly, you must pull out enough tax-deferred money to fill up your standard deduction and lower tax brackets to smooth out the total taxes you pay over retirement.
This is a must-know retirement strategy: fill standard deductions and low tax brackets with pre-tax money!
So, instead of the withdrawal sequence brokerage first, then pre-tax, then tax-free, oftentimes withdrawing from pre-tax accounts before you are forced to do so makes sense. This saves your brokerage account from being decimated and, importantly, decreases the sum of total taxes you pay over your lifetime.
Let’s look at this now.
Optimal Withdrawal Strategy: Using Pre-Tax Accounts to Fill in Lower Tax Brackets
Above, you can see two different scenarios.
In green, you don’t access your pre-tax account during your Tax Planning Window. This leads to a large pre-tax account and higher taxes down the line. In addition, once you are out of funds in your brokerage account, you are forced to liquidate your pre-tax account and pay more in taxes. Also, you are not filling up your lower tax brackets, leading to higher taxes down the line.
In blue, conversely, you take withdrawals from your pre-tax accounts during your tax planning window. Again, this lowers your overall taxes paid during your lifetime.
Taking your pre-tax money during your tax planning window allows you to utilize your lower tax brackets and save on taxes in the long run.
Tax Brackets and Asset Withdrawal Strategies
Above, you can see that we are taking out pre-tax money during our tax planning window to fill up the lower tax brackets.
Specifically, we have filled in the income using the 10 and 12/15% tax brackets (in addition to the standard deduction). This keeps our overall tax bill lower, as future required Minimum Distributions are smaller and don’t force distributions into higher tax brackets.
Unfortunately, there is still enough income to force part of it above the 12/15% tax bracket in this situation. Every withdrawal plan will differ depending on the assets you have and the order in which you sequence them.
Before we move on, let me clarify that the above fictional situation is for folks needing their pre-tax retirement account. Their plan does not call for partial Roth conversions.
Not everyone has the same withdrawal strategies in retirement.
What are some of the retirement income sources that we need to consider?
Sources of Income in Retirement: Assets to Consider
What are the sources of income in retirement?
IRAs and 401k plans represent the largest bucket of savings for most retirees. Unfortunately, this money is a ticking tax bomb and must be addressed early in the planning process. Taking this money in the most tax-efficient form is often the most important part of tax minimization.
Atypical Retirement Accounts
Think about 457 plans here. There are two very different flavors of plans. First, this represents accounts that have forced distributions. Inherited IRAs now fall under this category as the SECURE Act forces a ten-year distribution.
This will not be a major source of income for high-net-worth folks, but planning is important nonetheless. If you are married, you must defer social security for the highest earner to get the maximal COLA adjusted life-long guaranteed longevity insurance check for the surviving spouse.
Think about tax-efficient asset location when planning your asset location.
These are usually fully taxable, which has significant implications.
Rent or Royalty
Or other sources of “passive income.”
Don’t plan on inheritance in your retirement strategy. Sure, death is the only real guarantee in life. But perhaps only insurance companies and mortuaries should depend on death as a business model.
Human capital is an important part of retirement. Many folks enjoy the social interaction you get with part-time work. Even a small amount of income early on can mitigate known retirement risks, let alone positively affect retirement satisfaction.
Product to Consider in Retirement Withdrawal Strategies
What products might you consider as part of your strategic retirement income plan?
Remember, products have many different uses. Some generate income now, some later. Others have tax-free distributions or loans. Some mitigate common risks in retirement.
You need to understand the gap you are trying to fill, the need for a product, before considering what product you need. You also need to understand fees and contracts.
Products transfer risk. This is what is important to know. Do you want to handle all the known retirement risks yourself or do some risk pooling?
With Income and Longevity Annuities, you get mortality credits. Those who (unfortunately) die early allow these annuities to pay out more than income you would get from bonds alone.
However, some products “hope” you die early (like annuities), and some “hope” you die late (like life insurance). So an insurance company can hedge its bets by owning various products!
Let’s take a closer look at some of these products as sources of income in retirement.
Products to Consider as Withdrawal Strategies
Annuities are not a bad word. They are useful products, sometimes. However, they are complicated, so take some time to understand your options before buying. See How Annuities Might Work in Your Retirement Withdrawal Strategy.
Single premium immediate annuities are the most useful annuities for income. They provide income after a lump sum payment. They are relatively inexpensive, and you can comparison shop online. Few inflation-adjusted products are available, so these are not for longevity insurance. SPIAs are for income. Although SPIAs may not be great in this low-interest rate environment, consider a SPIA ladder (where you set aside safe money to purchase a SPIA in the future) for future income needs and longevity planning.
Deferred income annuities are also useful but not well known. They can be funded over time or with a lump sum payment, and the income is deferred and turned on later. These are also straightforward with low commissions and provide the best longevity insurance currently on the market, aside from social security. Understand that mortality credits are why SPIAs and DIAs can pay more than bonds or CDs.
Qualified longevity annuity contracts are DIAs in your retirement accounts. I’m going to go out on a limb and say that every wealthy person with a large IRA should consider a QLAC for longevity insurance. That is if you plan on living a long life. You can turn these on as late as 85. Although you can only put $130,000 in a QLAC if your deferral period is long enough, this will be real protection against both inflation and longevity.
Most folks should avoid Variable Annuities. Please don’t shoot the messenger, but they are complicated and expensive. On the other hand, if you are sophisticated or have a lot of time to waste with an annuity salesperson, you can talk about the benefits of withdrawal or income riders. For DIY, there are investment-only variable annuities IOVA, which can be considered.
Fixed Indexed Annuities are also avoided unless you know what you are doing. These products can benefit from the upside of an index but suffer no losses if the market goes down. They are sold without fees, but you lose in the market’s upside with participation rates and caps. If you want to take market risk off the table and use part of your bond allocation (not your equity allocation!) in FIAs with withdrawal riders, have at it. These are for the sophisticated DIY who desires to have a salesman work with them.
Multi-year guaranteed annuities pay a guaranteed rate every year for 3-10 years. These can be used instead of CDs or Bonds when making a ladder. They can be purchased online and can easily be compared to interest rates on CDs or Bonds. If you set aside money for future use, the DIY investor might find some use in a MYGA or two as part of their income ladder or as a Buffer Asset.
- Term life insurance can be considered in product allocation for its death benefit. It is more expensive to get term insurance the older you get
- Permanent life insurance for the death benefit. Indications for a permanent death benefit are considered appropriate uses of these complex and expensive products.
- Permanent life insurance for the cash value. These are less useful products, but often you have cash value as part of your permanent life insurance, which can be an important Buffer Asset.
- A home equity line of credit can be important in the transition period between salary and full retirement.
- HECM (home equity conversion mortgage), or a reverse mortgage, is an underutilized product. Despite the stigma, these can play a significant role in retirement income planning.
- Don’t forget the value of cash-flowing rental real estate in the retirement plan. This can be an important bond-like part of your income stream in retirement.
- Important to decide on lump sum or income stream (annuitization) depending on the internal rate of return offered. This is relatively straightforward math but important! If you have a pension, consider it important as the “third leg” of the retirement stool (Social Security, Pension, and Stock/Bonds)
- Single life or survivor benefits are an important consideration.
- Traditional pensions are becoming rare as employers switch from Direct Benefit plans to Direct Contribution plans where the employee takes on the investment risk. If you have a pension, consider it gold.
- Widow’s tax penalty is an important consideration. Almost always, the higher income earner should delay taking social security for as long as possible, up until 70. This is to establish as many delayed claiming credits as possible and provide the larger of the two checks for the Widow/Widower
- Longevity insurance as the payments never stop.
- Inflation protection through COLA adjustments. These are not inflated at true expenses for retirees but are important nonetheless.
Long-Term Care Insurance
- Traditional Long-Term Care insurance is optimal, but this is a complicated discussion
- Consider Self-Paying for LTC needs if you have >$2.5M in assets
- Hybrid LTCI/Life Insurance policies are confusing and expensive and should not be used if you have a large collection of pre-tax assets
This is not an exhaustive list of products, but it is a good start. What is on the other side of product allocation? The stock and bond market
Summary: Optimal Withdrawal Strategies for Retirement Income Portfolios
So, what have we learned?
An optimal Withdrawal Strategy is about taking your assets and turning them into income while mitigating known risks. You get income from your portfolio and control risk with your product allocation.
Use your various products and other assets in a cohesive retirement withdrawal strategy to accomplish retirement security.