When and How to Get the Money Out of Your 401(k) or IRA
Rules for Getting Your Money Out of a 401(k) or Other Retirement Plan
As your career days draw to a close, it's time to start thinking about the transition from living on your employment income to living on your savings. Beyond the emotional issues that make some of us terrified to break that piggy bank, you'll have many practical issues to face as well.
How much should withdraw initially? What rate of withdrawal over time will ensure that you won't outlive your savings, but still be substantial enough that you can enjoy life? Balancing a withdrawal rate with a growth rate is part of the science of investing for income.
Your retirement savings plan doesn't necessarily end when you begin retirement. That money still has a chance to grow, even as you withdraw funds to help pay for your living expenses. But the rate at which it will grow declines as you take out funds because withdrawals reduce the amount you have invested.
The 4 Percent Rule
Many financial advisers recommend the "4 percent rule" when evaluating how much you can take out of your retirement accounts without fear of outliving your savings. The idea is that you should be able to withdraw 4 percent annually and maintain financial security.
A famous study by Bill Bengen in the 1990s showed that a 4 percent withdrawal rate over 30 years had the best chance for success even as it adjusted for inflation. But several variables can make this rule of thumb either too conservative or too risky, and you might not be able to live on 4 percent a year unless your account has a significantly large balance.
Your Personal Situation
Some say that a 7 percent withdrawal rate is relatively safe, while others insist that realistic safety is closer to 2 percent, particularly in the first year or so. Like many financial solutions, the answer depends on your own unique circumstances: your life expectancy, the performance of your investments, how much you need to meet expenses, your spouse, Social Security, or a second job you might decide to take on.
You can run your own retirement calculations to get a sense of what you'll need and what you might be able to count on. There are many useful retirement calculators on the web, but it's a good idea to get advice from an unbiased financial professional as you near retirement.
Your Retirement Withdrawal Period
Bonds, stocks, real estate, and other types of assets pay either fixed or variable income. It's a common strategy to allocate more of your portfolio to fixed-income investments as you near retirement. Fixed income can be a safer bet, and it can also help shift your portfolio to a place where it's producing income rather than reinvested growth.
Income investments generate dividends or interest. Ideally, you could use that income to cover living expenses without touching the principal or the initial investment amount.
The problem is that it's hard to get any yield on your investments without taking on a lot of risk these days. And the payoff isn't huge even if you are willing to accept some risk.
What to Do? A Laddering Strategy
Many investors who seek a slight yield boost will try a laddering strategy with CDs, or with short and medium-term bonds. Investors want the highest available yield in a low and stagnant interest-rate environment. Longer-term bonds and CDs have higher interest rates than shorter-term bonds and CDs, but you run the risk of missing out on better-yielding investments should interest rates rise after you've locked in your money over a longer period of time.
A ladder strategy tries to blend the liquidity of short-term investments with the higher yields offered by longer-term investments. Instead of buying one five-year bond that pays 3 percent, you would buy five bonds that mature at different rates over the next five years. The shorter-term investments will pay less, and the longer-term will pay more.
Spreading your money across a variety of maturities can help you get a decent return without giving up your liquidity. You have a way to get your hands on the cash should you need it, and you can reinvest with bonds or CDs maturing each year. Hopefully rates will be better by then.
Which Account Should You Withdraw From First?
Another consideration is which account to draw from first. How to do this in the most tax-efficient way also depends on your individual situation. You can start withdrawing funds from a retirement account without penalty after age 59 1/2, but you don't have to start taking required minimum distributions (RMDs) from tax-deferred retirement accounts until age 70 1/2.
A Roth IRA works differently. There are no RMDs, so you can let that money grow tax-free for as long as you like.
You might want to strategize your withdrawals to reduce your annual tax bill in some cases. Withdrawals from a Roth IRA are tax-free in retirement, so you might want to take some money from that fund rather than another.
Talk to a financial adviser or your plan administrator to determine the best strategy for you if you have a combination of investment accounts. You might also consider converting to a Roth IRA before or during retirement. Again, a financial professional can outline whether this makes sense depending on your needs and goals.
What Happens to Unused 401(k) Savings?
If you don't outlive your funds or you're not able to withdraw all your retirement funds before death, the money will be passed on to the beneficiaries you named when you opened the accounts. It's a good idea to check in with your beneficiaries periodically, or after a life change such as marriage, the birth of a child, or divorce, because they'll pay income tax on these withdrawals.
The content on this site is provided for information and discussion purposes only. It should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation.