Whether retirement is thirty years from now or three, it’s important that you know what your options are for maximizing your nest egg and making it last as long as possible. Over the past few months, we have focused on strategies for implementing a retirement savings plan as well as methods for calculating monthly expenses while in retirement. In this article, we will look at three options for withdrawing funds while in retirement.
While there are countless methods for drawing down on assets during retirement, the three that I intend to focus on are: 4% Rule, Dividend Producing Assets, and using tax laws such as Required Minimum Distribution as a guide for monthly spending.
One of the oldest and still most prevalent tools for ensuring your money outlasts you is the 4% rule (for all of our retirement calculations, we will assume a $50,000 portfolio). Following this rule, a retiree with $50,000 would plan on withdrawing $2000 in the first year of retirement (or approximately $167 per month). For subsequent years, she would increase the withdrawal rate by the rate of inflation. This sounds like a pretty straightforward plan, easy to calculate and simple to execute. The simplicity of this rule is precisely why it has gained so much attention in the past 20 years.
However, the 4% rule does have flaws. In the same way telling someone midcareer that saving 10% of their salary will be sufficient for retirement, the 4% rule does not take into account enough factors. Some of these factors are: life expectancy, income demands and spending habits of the retiree, as well as future medical expenses and current market factors. If, for example, we are on the cusp of a five-year bear market, and a retiree begins withdrawing 4%, it is a very good chance the retiree will outlast his money.
Dividend Producing Assets
A second retirement option is to live strictly off the dividends that are produced by a retirement account. For most retirees, this is not an option, as you need significant amounts of capital in order to produce dividends sufficient for income on a monthly basis. According to the Employee Benefit Research Institute, 60% of Americans have less than $25,000 accumulated in savings (excluding home-equity and defined benefit plans). This means that nearly two out of every three Americans would not be able to generate more than approximately $100 a month from dividend producing assets.
The other concern is growth. With a portfolio invested strictly in dividend producing assets such as bonds, you sacrifice significant growth potential for a 20+ year retirement. Many retirees will add a certain percentage of stocks in their portfolio during retirement in order to insure their money outlasts them.
Required Minimum Distribution
The final method worth evaluating is to base retiree spending on the Required Minimum Distribution. For a list of frequently asked questions concerning required minimum distributions from the IRS website, go here (you may have to copy paste the link into an address bar):
Tax laws governing required minimum distributions allow the IRS to tax monies that have been growing tax-free for decades. So when will you need to start taking these distributions? Straight from the IRS website:
An account owner must take the first RMD for the year in which he or she turns 70 ½. However, the first RMD payment can be delayed until April 1st of the year following the year in which he or she turns 70 ½. For all subsequent years, including the year in which the first RMD was paid by April 1st, the account owner must take the RMD by December 31st of the year.
The IRS’ Uniform Lifetime Table uses a retiree’s age to determine the required distribution. For a 70-year-old, the factor is 27.4. Dividing $50,000 by 27.4 gives us a required minimum distribution of $1824. Taking this figure, and dividing it by 12 amounts to $152 a month in additional income.
Click here, for an excellent article regarding required minimum distributions.
Each year, the required minimum distribution is calculated using a different factor for age, and the account value on December 31 for the previous year. In addition, each year the factor decreases, requiring a bigger distribution.
Which Method Should I Choose?
We are therefore left to analyze which of the three options make the most sense. Certainly the 4% rule has merit for very general planning purposes. However, a combination of living solely off of dividends as well as an eye on the required minimum distribution going into retirement will give us greater confidence of outliving our portfolio. In addition, adjusting these numbers will be required for either: a dramatic increase (or decrease) in the portfolio’s value, and/or reaching the age which corresponds to a higher distribution factor.