Limitations Of The Safe Withdrawal Rate Method
A shortcoming of the safe withdrawal rate method is that depending on when you retire, the economic conditions can be very different from what initial retirement models assume. A 4% withdrawal rate may be safe for one retiree yet cause another to run out of money prematurely, depending on factors such as asset allocation and investment returns during retirement.
In addition, retirees dont want to be overly conservative in choosing a safe withdrawal rate because that will mean living on less than necessary during retirement when it would have been possible to enjoy a higher standard of living. Ideally, though this is rarely possible because of all the unpredictable factors involved, a safe withdrawal rate means having exactly $0 when you die, or if you want to leave an inheritance, having exactly the sum you want to bequeath.
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Expecting Relatively Large Long
Spreading traditional IRA withdrawals out over the course of retirement lifetime may make sense for many people. However, if an investor anticipates having a relatively large amount of long-term capital gains from their investmentsenough to reach the 15% long-term capital gain bracket thresholdthere may be a more beneficial strategy: First, use up taxable accounts, then take the remaining withdrawals proportionally.
The purpose of this strategy is to take advantage of zero or low long-term capital gains rates, if available based on ordinary income tax brackets. Tax rates on long-term capital gains are 0%, 15% or 20% depending on taxable income and filing status. Assuming no income besides capital gains, and filing single, the total capital gains would need to exceed $40,400 after deductions, before taxes would be owed.
Tax rates: Singles
One strategy for retirees to help reduce taxes is to take capital gains when they are in the lower tax brackets. For example, single filers with taxable income less than $40,400 are in the 2 lower tax brackets. That equates to a 0% tax on capital gains. If taxable income is between $40,401 and $445,850, long-term capital gains rate is 15%. Remember, the amount of ordinary income impacts long-term capital gain tax rates.
The big difference: Jamie pays zero on her long-term capital gains because her income is below that key threshold of $40,400, but David pays 15% on his $5,000 because of his higher earnings.
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My Retirement Withdrawal Strategy
That said, I can tell you what Im doing with these results. This isnt an academic exercise for me. I am retired. I am living off my assets. I need a withdrawal strategy.
I have more confidence in historical simulations than I do in artificial Monte Carlo approaches or mere speculation about the future. Though historical simulations cant predict future outcomes, I think they are a good way to test investing behavior. Other factors being equal, behaviors that were beneficial in the past will tend to be beneficial in the future.
These results show that the order in which you liquidate asset classes can make a substantial difference in your overall retirement income. Two withdrawal strategies stand out: Equal Withdrawals for its simplicity, and the CAPE Median for its performance. Equal Withdrawals is dead simple, and the CAPE Median isnt much harder. To use it, when you need cash in retirement, you look up CAPE on the web. If its greater than the long-term median , you sell some stocks. If its less, you sell some bonds.
According to my research, if you do this consistently, youll come out ahead, possibly way ahead, of other withdrawal strategies. So thats what Ill be doing, until I learn something better.
And, if youre skeptical or want to keep it even simpler, my research shows that, if your allocation is around 50/50, you can just sell equal amounts of your stocks and bonds each year, ignore rebalancing, and likely do very well, beating most other strategies.
* * *
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Follow The Rules For Rmds
You must take RMDs annually by April 1 of the year after you turn 72 and by Dec. 31 in subsequent years. In other words, if you turn 72 in 2021, you have until April 1, 2022, to take your first RMD.
The penalty for not following the rules is severe. Failure to make on-time RMDs triggers a whopping 50 percent excise tax.
Thats true if you underpay, too. Lets say your RMD for the year is $20,000 but you take only a $5,000 distribution because of a miscalculation. The IRS will levy the 50 percent penalty in this case $7,500, or half of the $15,000 you failed to withdraw.
When you calculate your RMD, be aware that it will change from year to year. Thats because its determined by your age, life expectancy and account balance, which will be the fair market value of the assets in your accounts on Dec. 31 the year before you take a distribution.
Check out the Uniform Life Table in IRS Publication 590-B to help figure what you must withdraw from your account.
Next Steps To Consider
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
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Levers Affecting Withdrawal Rates
This graph illustrates the spectrum of withdrawal rates from lower to higher and the 4 factors that determine how much or how little you should withdraw. The first line, Time horizon, shows with a longer horizon the withdrawal rate should be lower while with a shorter one it can be higher. The second line, Asset allocation, shows a more conservative asset allocation leads to a lower withdrawal rate while a more aggressive one correlates with a higher rate. The third line, Spending flexibility, shows less flexibility means a lower withdrawal rate and more flexibility means a higher rate. The fourth line, Degree of certainty desired, shows if a higher degree of certainty is sought than the withdrawal rate should be lower and with lower degree of certainty the withdrawal rate is higher.
Alternatives To The Safe Withdrawal Rate Method
People often make the mistake in retirement that they continue spending too much even at times when their portfolio is down. This behavior can increase the possibility of failure rate, or the percentage of simulated portfolios that fail to last to the end of a person’s expected retirement.
An alternative to the safe withdrawal rate method is dynamic updatinga method that, in addition to considering projected longevity and market performance, factors in the income you might receive after retirement and reevaluates how much you can withdraw each year based on changes in inflation and portfolio values.
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Tax Optimize Ira Conversions Into A Roth
If we defer our pension, it also means our income will be zero during the deferral period. This will provide an ideal opportunity to pull heavily from our Before-Tax funds and convert them into after-tax and/or Roth at the lowest possible tax rate. Since Ill be 55 when I retire, I can pull 401 Before-Tax money without penalty, a small loophole in the IRA code that gets us around the traditional Age limit of 59.5 normally associated with withdrawing tax-favored retirement funds.
Were planning on withdrawing before-tax money right up to the limit of the marginal tax brackets during the time of the pension deferral. Ultimately, it will also reduce our Required Minimum Withdrawals at Age 70.5, which may otherwise force us up into higher tax brackets due to the fact that the RMD is taxable.
Its complex, but I think itll work. Im planning on lining up a meeting with my CPA to talk through the specifics, but it affords a limited time opportunity to adjust that 56% Before-Tax slice of the pie in our Tax Allocation chart shown earlier.
Rmds Can Be Delayed For Some Workers
Putting off your retirement? If youre still working at age 72 and continuing contributions into a 401 or 403, youre entitled to an RMD reprieve as long as you dont own more than 5 percent of a company and your retirement plan lets you. If these conditions apply, you can delay the RMDs until April 1 after the year that you separate from service, at which point youll have to start taking withdrawals.
This is true as long as you work during any part of a year. So if youre 72 ½ years old and thinking about retiring by the end of the calendar year, reconsider if you dont want to make a withdrawal. If you keep working after Jan. 1 even if its just a day youll push off the date for taking that first RMD by one more year.
Keep in mind that the delay only counts for the 401 plan of the company youre still working for. If you have other 401 plans from previous jobs, youll need to take distributions from them if youre 72 or older.
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Advantages Of Retirement Withdrawals Based On Life Expectancy
This approach has some intuitive appeal. You are dividing your money up evenly according to how many years you expect to remain living. And that expectation is updated annually based on statistics.
Again, you will never run out of money! But again, there is no guarantee exactly how much money youll have in your last year.
Put A Withdrawal Plan In Place
When a retiree starts needing withdrawals, what accounts should they draw from first?
Start by evaluating the ratio of taxable account assets to tax-deferred and tax-free account assets. If all of the assets are in 401 or IRA plans, there isnt much need for further analysis, because withdrawals will be subject to ordinary income tax.
However, if a retiree has a mix of assets, we can determine which accounts should be tapped first by reviewing the persons age and their tax bracket. A person with $1 million or more in assets may be in the top federal tax bracket when you factor in all of their other income sources, which means they will pay 39.6% in taxes. This means that any withdrawals should come from more tax-favored accounts if possible, such as cash or taxable brokerage accounts, which are taxed at lower capital gains rates.
For example, consider a person who has invested $500,000 in a taxable brokerage account, which has now grown by 20% to a grand total of $600,000. Approximately 20% of their withdrawals will be subject to capital gains taxes and 80% of withdrawals could be subject to 0% tax as its a return of their principal.
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Ways To Withdraw Money In Retirement
It’s official: You’re retired. That probably means no more regular paycheck, and you may need to turn to your investments for income. But remember: The impact of taxes is just as important to consider now as it was when saving for retirement.
The good news is that in retirement there may be more options to increase after-tax income, especially when savings span multiple account types, such as traditional retirement accounts, Roth accounts, and taxable savings like brokerage or savings accounts. The not-so-good news is that choosing which accounts to draw from and when can be a complicated decision.
“Many people are seeking ways to help reduce the taxes that they will pay over the course of their retirement,” says Andrey Lyalko, vice president of Fidelity financial solutions. “Timing is critical. So, how and when you choose to withdraw from various accounts401s, Roth accounts, and other accountscan impact your taxes in different ways.”
Taxes matter: How different accounts are taxed
|0% long-term capital gains rate if ordinary taxable income is within applicable ranges||
||Has no impact on any tax calculation|
How Does The 4% Rule Of Thumb Work
If you retire with $1 million in your portfolio, youd withdraw $40,000 in the first year, according to the rule. Going forward, youd withdraw $40,000 plus inflation. If inflation in year two is 3%, for example, you would withdraw $41,200. The additional $1,200 compensates for inflation, ensuring you can maintain your standard of living.
Keeping your portfolio invested during retirement allows you to earn an average return over time. In theory, your investments will grow, preventing you from depleting your funds too quickly.
If youre unsure how much you can afford to withdraw each year without running out of funds, the 4% rule is a good starting point.
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Blending Withdrawals From Ira And Taxable Accounts
Given that taking full distributions from the IRA up front can drive the couple into higher tax brackets, and taking full distributions from the IRA in the later years will also drive the couple into higher tax brackets, the solution is actually remarkably simple: to take distributions from each account along the way.
The benefit of this tactic is that by taking only partial distributions from the IRA each year, the distributions can occur at “only” the 15% bracket without ever reaching the 25% bracket. Yet by taking at least some withdrawals from the IRA every year, the brokerage account lasts longer before it is ever depleted . For instance, the chart below shows the results when the retiree takes half the desired spending from each account every year, assuming their tax-savvy withdrawals keep them in the 15% tax bracket throughout.
Notably, the spend-brokerage-account-first scenario still had a higher final account balance, but this is due in large part to the fact that the IRA still has a significant looming tax liability that will have to be spent someday . On a net after-tax basis, the split-strategy that allows the IRA withdrawals to be blended across the 10% and 15% brackets actually fares better than either of the alternatives!
Figure Out Health Care Insurance:
A BIG issue and one which Im starting to study in detail is how were going to manage the mine-laded field of private health care insurance. Ive built a worksheet with links to everything I can find on the options, and well be making our Private Pay Health Care decision prior to retirement. Probably some posts on this one, its a biggie, and we dont yet know what were going to do. Weve budgeted $20k/year for health care/insurance, but I fear thats insufficient. What a mess..
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How Do I Account For Inflation In Retirement Planning
Inflation should always be a key part of your retirement plan, from the time you start investing until you’re making your annual withdrawal plan. Since inflation tends to average between 2% and 3% per year, the total amount you’ll need when you retire should account for that increase, and your annual withdrawal amount will need to increase based on inflation each year during retirement.
Holdfast Phase Withdrawal Plan
We are 7 years into the holdfast phase, but this is still beginning. Once Mrs. RB40 retires, well probably have to make some adjustment. We should be able to continue saving as long as I continue with blogging. Here is the plan after Mrs. RB40 retires.
- Passive incomeOur passive income now exceed our expense! However, I havent look at taxes yet. Its a bit too complicated to estimate right now. Luckily, we have income from other sources.
- Online income My online income is good this year, but it can be volatile. My blog income probably will drop significantly if we have a recession.
- Side hustles I have several side hustles charge scooters, market research, JobSpotting, and more. These side hustles dont generate a lot of income, but they dont take much time either. The income goes straight into savings. Mrs. RB40 might work a bit after retiring from her full-time job too.
As long as we keep our lifestyle inflation reasonable, these sources of income should cover our expense until were 65. Social Security benefits and pension will kick in a couple of years later at 67. Retirement should be smooth sailing after that point. I doubt Ill ever stop working completely, though. Working part-time is really good. It helps me stay physically and mentally active. Full retirement can wait until Im 80.