Five Retirement Drawdown Approaches
Upon retirement, you'll likely rely on your retirement accounts to supplement Social Security income. To ensure your funds last, you'll need to devise a retirement withdrawal strategy. This strategy helps determine a safe amount of money to withdraw annually from your investment accounts, thereby impacting your retirement income and lifestyle. Choosing the optimal strategy protects your accounts from depletion while you're still dependent on your savings.
A retirement withdrawal strategy can safeguard your finances during retirement by providing a framework for distributing your savings. The strategy you select will determine your income, which ultimately affects your lifestyle and longevity of your savings.
Factors impacting your strategy selection include the sum of your savings, anxiety about depleting your funds, considering early retirement with the Financial Independence Retire Early (FIRE) strategy, and the required income your investments should generate.
Regardless of the strategy, you must withdraw a sufficient sum from tax-advantaged investment accounts (such as your SEP, SIMPLE, traditional IRA, or 401(k)) to comply with Internal Revenue Service (IRS) rules for Required Minimum Distributions (RMDs).
RMD guidelines mandate annual withdrawal of a predefined portion of your investment account balance following age 73. Failure to withdraw the stipulated amount incurs a 25% tax penalty, although prompt correction of the oversight can reduce the penalty to 10%.
RMDs were typically applicable to some after-tax Roth accounts, including Roth 401(k)s. However, under the new Secure Act 2.0 rules starting in 2024, RMDs will not be required for Roth accounts.
The 4% rule
Following the 4% rule signifies withdrawing 4% of your investment account balance in the first retirement year. Annually, you would increment the amount to keep pace with inflation, the escalating cost of goods and services.
If you adopted the 4% rule while commencing retirement with a $500,000 nest egg, you'd withdraw $20,000 in the initial year. With 2% inflation (the Federal Reserve's target rate of inflation), you'd withdraw $20,400 in the subsequent year.
The main advantage of the 4% rule is its simplicity, as it allows your buying power to keep pace with inflation. However, increased interest rates and market volatility pose a risk of exhausting your funds using this approach. Unfortunately, it lacks flexibility to adjust based on investment performance.
The diagram below illustrates the income available during a 20-year retirement, assuming initial retirement in 2020 and following the 4% rule with 2% inflation and an average 3% annual investment return throughout retirement (ending in 2040). If you maintained this withdrawal schedule, your account balance would be approximately $243,518 at the end of 20 years.
Fixed-dollar withdrawals
Fixed-dollar withdrawals involve annual extraction of a fixed amount from your retirement account over a specified duration (e.g., $20,000 annually for five years, followed by reassessment).
The primary advantage of fixed-dollar withdrawals is their predictable annual income and the ability to set the withdrawal amount based on your first-year retirement budget. The drawbacks include the loss of purchasing power due to inflation unless the amount is periodically adjusted and the potential of running out of money if the fixed-dollar amount is set too high.
The table below demonstrates the approximate purchasing power of a $20,000 annual withdrawal over time (assuming a 2% inflation rate).
| Year | Purchasing Power ||-------|------------------|| 1 | $20,000 || 5 | $13,768 || 10 | $9,991 || 15 | $7,388 || 20 | $5,804 |
Fixed-percentage withdrawals
Fixed-percentage withdrawals entail withdrawing a predetermined percentage of your investment account balance annually (e.g., 3.5% or 4%). The withdrawal amount varies as the account balance fluctuates. This method differs from the 4% rule by using a different percentage and maintaining the same percentage rather than adapting it based on inflation.
The main advantage of this approach is its adaptability to market fluctuations. However, choosing a too-large percentage may leave you with insufficient funds, and income fluctuation makes long-term financial planning challenging.
Systematic withdrawals
Systematic withdrawals involve withdrawing only the income your investments produce through interest or dividends, leaving your principal invested throughout retirement. The benefit of this method is the inability to exhaust your retirement account of funds. However, a substantial account balance is required to provide adequate income, and income fluctuation impacts financial planning.
Buckets
Implementing a bucket strategy entails having three distinct sources of retirement income:
- A savings account containing approximately three to five years' worth of living expenses in cash
- Fixed-income securities, such as government and corporate bonds or certificates of deposit
- Equity investments.
When this strategy is employed, you have three separate sources of income, making it easier to manage your finances during retirement. This method safeguards your funds, ensures a steady income, and allows for adjustments based on market performances.
With this strategy, you dip into your savings account to cover your expenses and replenish that "reservoir" with funds from the other two sources. This strategy helps you avoid selling off assets at a loss. Whenever you replenish your savings account, you do so by offloading shares if the market is booming or by disposing of your well-performing fixed income securities. In case both stocks and bonds are performing poorly, you carry on with this process from your savings.
This approach provides you with more control over when to sell your investments and has the potential to boost your investment account balance gradually. However, this method can become quite time-consuming, and you would still need to utilize another method to calculate what you can afford to spend annually.
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Social Security Benefits
This government-funded program aids those in need, drawing from funds generated by specific taxes. Our website includes a disclosure policy. (Note: The disclosure policy doesn't affect the paraphrased text.)
Your retirement withdrawal strategy can directly impact your retirement income, potentially affecting the longevity of your savings. To avoid running out of money in retirement, you might consider allocating a portion of your retirement funds to money market accounts or bonds, which offer a steady income stream and minimal risk.
Considering your retirement income sources, Social Security income and your retirement accounts will only cover a part of your necessary expenses in retirement. Therefore, it's crucial to supplement this income with additional savings that can generate money, ensuring a comfortable retirement lifestyle.
