Retirement Planning, Part 4: Withdrawing Money in Retirement
Eileen St. Pierre, The Everyday Financial Planner
According to the Pew Research Center, 10,000 baby boomers enter retirement every day and this pace is expected to continue until the last of this generation reaches age 65 in 2030. This generation has seen the demise of the pension, along with its steady monthly retirement checks. Now boomers need to figure out how to withdraw the money they worked so hard to accumulate.
Timeline for Retirement
First, let’s talk about a few important age milestones:
- Age 59 ½: No more tax penalties for early withdrawals from retirement accounts
- Age 62: Minimum age to receive Social Security benefits
- Age 65: Eligible for Medicare
- Age 66: Born 1943-1954, eligible for full Social Security benefits. For those born 1955-1959, add 2 months per year to get your normal retirement age (for more information, visit the Social Security website)
- Age 67: Born 1960 and later, eligible for full Social Security benefits
- Age 70 ½: Start taking required minimum distributions to avoid penalties (does not apply to Roth IRAs)
It’s a fact of life – some of us will be forced to retire before we planned. If you withdraw money from your retirement accounts before age 59 ½, you will have to pay a 10% penalty. If you leave your job and are at least 55, you can start withdrawing from your employer’s retirement plan without the penalty.
Don’t take your decision regarding when to claim Social Security benefits lightly. Claiming benefits before your normal retirement age will lead to a reduced benefit (as high as 30%) for the rest of your life. If you wait until after your normal retirement age, your benefit will rise by 8% per year until you reach age 70 (when there is no further benefit from waiting).
Know all those income taxes you deferred by investing in your 401(k) and IRAs? Well, the IRS wants to start collecting them. At age 70 ½, you need to start taking required minimum distributions (RMD) from your tax deferred accounts, or pay a 50% penalty on the RMD amount. You decide which tax-deferred account from which to make your RMD. The IRS has formulas you can use to determine your RMD, or you can also use an online RMD calculator . Your investment company should also be able to tell you. Divide the amount by 12 to determine how much to withdraw each month.
Roth 401(k) and 403(b) accounts are also subject to RMD rules but your withdrawals will be tax-free. Roth IRAs are the only accounts that avoid RMD rules. So you can wait as long as you want before withdrawing from your Roth IRA. Avoid RMDs on your Roth 401(k) or 403(b) by rolling it over into a Roth IRA.
Calculate Monthly Income
Monthly Income = Social Security + Pension + Income from Retirement Accounts + Other Income
Add up your monthly Social Security benefit, pension payment, and RMD amount and determine if it covers your expenses. You can choose to withdraw more than the RMD amount, or you can see if you can trim expenses. You may also have other income from working in retirement.
Just how much should you withdraw from your retirement portfolio each year? Many financial advisors recommend a withdrawal rate of 4%. There isn’t a 100% chance you will not run out of money, but the odds are pretty good you’ll have enough. Keep in mind this formula:
Return ≥ Withdrawal Rate + Inflation Rate
If your withdrawal rate is 4% and inflation runs around 3%, your portfolio needs to earn at least 7% to make sure you do not run out of money. If the return on your portfolio goes down, you will need to reduce your withdrawal rate. So if you have a low risk tolerance and have invested your retirement portfolio accordingly, you need to lower your withdrawal rate. This is why it is important to keep some stock in your portfolio even after you retire.
Let’s say you need an extra $1,000 in monthly income to supplement your Social Security (you do not have a pension). You will need to have $300,000 in savings for every $1,000 of monthly income:
$300,000 x 4% annual withdrawal rate = $12,000 per year ÷ 12 months = $1,000 per month
We have been told to always have 3 to 6 months of living expenses in our emergency savings fund. In retirement, it’s important to keep a larger cash cushion to cover unexpected events such as an extended illness, appliance replacement, or car repair. If you keep 1 to 2 years of living expenses in your emergency savings fund at all times, this will keep you from having to sell assets in down markets. So if you find you do not need to spend your entire RMD amount in a particular year, put that money in your emergency savings fund.
Everyone wants to be able to enjoy their retirement years. Putting a plan in place on how to withdraw your money in retirement lets you worry about more important things like finding cheap plane tickets to visit your grandkids and getting to the restaurant in time for the early-bird special.
Visit my Retirement Planning page for more information.