During your working years, you regularly set aside funds in tax-deferred retirement accounts such as a 401(k) or IRAs. You also probably saved additional money in taxable accounts. Your challenge during retirement will be to convert those assets into an annual income stream that provides enough to meet your various goals, without ever running out of money.
Setting a withdrawal rate
The retirement lifestyle you can afford will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, is known as your withdrawal rate. Figuring out an appropriate initial withdrawal rate is a key retirement planning challenge. Why? 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, as it will have a lasting impact on how long your savings last.
One widely used rule of thumb on withdrawal rates for tax-deferred retirement accounts is to try and take no more than 4% annually from a balanced portfolio of large-cap stocks and bonds. This will hopefully provide inflation-adjusted income that will last for 30+ years. Some experts contend that a higher withdrawal rate (closer to 5%) may be possible in the early, active retirement years if later withdrawals are carefully managed. Others suggest adding asset classes and freezing the withdrawal amount during years of poor market performance. By doing so, they argue, "safe" initial withdrawal rates around 5% might be possible.
Don't forget that these hypotheses are based on historical data about various types of investments, and past results do not guarantee future performance. There is no standard rule of thumb that works for everyone--your particular withdrawal rate needs to take into account a host of factors, including, but not limited to, your asset allocation and projected rate of return, annual income targets (accounting for inflation as desired), and your investment horizon.
Which assets should you draw down first?
You may have assets in accounts that are taxable (CDs, savings and brokerage accounts), tax-deferred (a 401(k) and traditional IRAs), and tax-free (Roth IRAs). Given a choice, which type of account should you withdraw from first? Not surprisingly, the answer is—it depends.
If leaving a legacy to your beneficiaries isn’t a priority, consider first withdrawing money from taxable accounts, then tax-deferred accounts, and lastly your tax-free accounts. By using your more tax-favored accounts later, and avoiding taxes as long as possible, you'll keep more of your retirement dollars working for you.
If leaving a legacy to your heirs is an important goal, however, the analysis becomes a bit more complicated. You’ll need to coordinate your retirement planning with your estate plan. For example, if you have certain highly appreciated or rapidly appreciating assets in your IRAs or 401(k), it might be better for you to withdraw from those accounts first. This is because assets in tax-deferred accounts will not receive a step-up in basis at your death, as many of your other assets will.
This isn’t always the best strategy, though. 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 spouses are given preferential tax treatment with regard to retirement plans. A surviving spouse can roll over retirement plan funds to their own IRA or retirement plan, or, in some cases, may take over their deceased spouse's plan. The funds in the plan continue to grow tax-deferred, and distributions need not begin until the spouse turns age 72.
The bottom line is that it can be a complicated decision. Your Truist Wealth advisor can help you determine the best course based on your individual circumstances.
Certain distributions are required
In practice, your choice of which assets to draw first may, to some extent, be directed by tax rules. You can't keep your money in tax-deferred retirement accounts forever. Whether you need the money or not, the law requires you to start taking required minimum distributions (RMDs) from your traditional IRAs by April 1 of the year following the year you turn age 72. For employer plans, the same timetable applies unless you continue to work, in which case you can delay 401(k) distributions until the year you retire. Roth IRAs, on the other hand, aren't subject to any RMD requirements.
If you have more than one IRA, a required distribution is calculated separately for each IRA. These amounts are then added together to determine your RMD for the year. You can withdraw your RMD from any one or more of your IRAs. (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.)
It's 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’ll be subject to a tax penalty equal to 50% of the amount you failed to withdraw. The good news? You can always withdraw more than your RMD amount.
If you've used an annuity for part of your retirement savings, at some point you'll need to consider your options for converting the annuity into income. You can choose to simply withdraw earnings (or earnings and principal) from the annuity. There are several ways of doing this. You can withdraw all of the money in the annuity (both the principal and earnings) in one lump sum. You can also withdraw the money over a period of time through regular or irregular withdrawals. By choosing to make withdrawals from your annuity, you’ll continue to have control over the money that’s invested in the annuity. But if you systematically withdraw the principal and the earnings from the annuity, there’s no guarantee that the funds will last for your entire lifetime—unless you’ve purchased a separate rider that provides guaranteed minimum income payments for life (without annuitization).
In general, your withdrawals will be subject to income tax—on an "income-first" basis—to the extent your cash surrender value exceeds your investment in the contract. The taxable portion of your withdrawal may also be subject to a 10% early distribution penalty if you haven't reached age 59½, unless an exception applies.
A second distribution option is called the guaranteed1 income (or annuitization) option. If you select this option, your annuity will be "annuitized," which means that the current value of your annuity is converted into a stream of payments. This allows you to receive a guaranteed1 income stream from the annuity. The annuity issuer promises to pay you an amount of money on a periodic basis (monthly, yearly, etc.).
If you elect to annuitize, the periodic payments you receive are called annuity payouts. You can elect to receive either a fixed or variable amount for each payment period. You can receive the income stream for your entire lifetime (no matter how long you live), or you can receive the income stream for a specific time period (e.g., 10 years). You can also elect to receive annuity payouts over your lifetime and the lifetime of another person (called a "joint and survivor annuity"). The amount you receive for each payment period will depend on the cash value of the annuity, how earnings are credited to your account (whether fixed or variable), and the age at which you begin receiving annuity payments. The length of the distribution period will also affect how much you receive. For example, if you are 65 years old and elect to receive annuity payments over your entire lifetime, the amount of each payment you'll receive will be less than if you had elected to receive annuity payouts over five years.
Each annuity payment is part non-taxable return of your investment in the contract and part payment of taxable accumulated earnings (until the investment in the contract is exhausted).