*Guarantees are subject to the claims-paying ability and financial strength of the issuing insurance
Converting Savings to Retirement Income
During your working years, you've probably set aside funds in retirement accounts
such as IRAs, 401(k)s, or other workplace savings plans, as well as in taxable
accounts. Your challenge during retirement is to convert those savings into an
ongoing income stream that will provide adequate income throughout your
Setting a withdrawal rate
The retirement lifestyle you can afford will depend not only on your assets and
investment choices, but also on how quickly you draw down your retirement
portfolio. The annual percentage that you take out of your portfolio, whether
from returns or both returns and principal, is known as your withdrawal rate.
Figuring out an appropriate initial withdrawal rate is a key issue in retirement
planning and presents many challenges. Why? Take out too much too soon, and you
might run out of money in your later years. Take out too little, and you might
not enjoy your retirement years as much as you could. Your withdrawal rate is
especially important in the early years of your retirement, as it will have a
lasting impact on how long your savings last.
One widely used guideline on withdrawal rates for tax-deferred retirement
accounts that emerged in the 1990s stated that withdrawing slightly more than 4% annually from a balanced
portfolio of large-cap equities and bonds would provide inflation-adjusted
income for at least 30 years. However, more recent studies have found that this guideline may be too generalized. Individuals may not be able to sustain a 4% withdrawal rate, or may even be able to support a higher rate, depending on their individual circumstances.
The bottom line is that there
is no standard guideline that works for everyone — your particular withdrawal
rate needs to take into account many factors, including, but not limited to,
your asset allocation and projected rate of return, annual income targets
(accounting for inflation as desired), investment horizon, and life expectancy. 1
Which assets should you draw from first?
You may have assets in accounts that are taxable (e.g., CDs,
mutual funds), tax deferred (e.g., traditional IRAs), and tax free
(e.g., Roth IRAs). Given a choice, which type of account
should you withdraw from first? The answer is — it depends.
For retirees who don't care about leaving an estate to beneficiaries, the answer
is simple in theory: withdraw money from taxable accounts first, then
tax-deferred accounts, and lastly, tax-free accounts. By using your tax-favored
accounts last, and avoiding taxes as long as possible, you'll keep more of your
retirement dollars working for you.
For retirees who intend to leave assets to beneficiaries, the analysis is more
complicated. You need to coordinate your retirement planning with your estate
For example, if you have appreciated or rapidly appreciating assets, it
may be more advantageous for you to withdraw from tax-deferred and tax-free
accounts first. This is because these accounts will not receive a step-up in
basis at your death, as many of your other assets will.
However, this may not always be the best strategy. For example, if you intend to
leave your entire estate to your spouse, it may make sense to withdraw from
taxable accounts first. This is because spouses are given preferential tax
treatment with regard to retirement plans. A surviving spouse can roll over
retirement plan funds to his or her own IRA or retirement plan, or, in some
cases, may continue the deceased spouse's plan as his or her own. The funds in
the plan continue to grow tax deferred, and distributions need not begin until
the spouse's own required beginning date.
The bottom line is that this decision is also a complicated one. A financial
professional can help you determine the best course based on your individual
Certain distributions are required
In practice, your choice of which assets to draw first may, to some extent, be
directed by tax rules. You can't keep your money in tax-deferred retirement
accounts forever. The law requires you to start taking distributions — called
"required minimum distributions" or RMDs — from traditional IRAs by April 1 of
the year following the year you turn age 72, whether you need the money or not.
For employer plans, RMDs must begin by April 1 of the year following the year
you turn 72 or, if later, the year you retire. Roth IRAs aren't subject to the
lifetime RMD rules. (Beneficiaries of either type of IRA are required to take RMDs after the IRA owner's death.)2
If you have more than one IRA, a required distribution is calculated separately
for each IRA. These amounts are then added together to determine your RMD for
the year. You can withdraw your RMD from any one or more of your IRAs. (Your
traditional IRA trustee or custodian must tell you how much you're required to
take out each year, or offer to calculate it for you.) For employer retirement
plans, your plan will calculate the RMD, and distribute it to you. (If you
participate in more than one employer plan, your RMD will be determined
separately for each plan.)
It's important to take RMDs into account when contemplating how you'll withdraw
money from your savings. Why? If you withdraw less than your RMD, you will pay a
penalty tax equal to 50% of the amount you failed to withdraw. The good news:
you can always withdraw more than your RMD amount.
If you've used an annuity for part of your retirement savings, at some point
you'll need to consider your options for converting the annuity into income. You
can choose to simply withdraw earnings (or earnings and principal) from the
annuity. There are several ways of doing this. You can withdraw all of the money
in the annuity (both the principal and earnings) in one lump sum. You can also
withdraw the money over a period of time through regular or irregular
withdrawals. By choosing to make withdrawals from your annuity, you continue to
have control over money you have invested in the annuity. However, if you systematically withdraw the principal and the earnings from the annuity, there is no guarantee that the funds in the annuity will last for your entire lifetime, unless you have separately purchased a rider that provides guaranteed minimum income payments for life (without annuitization).
In general, your withdrawals will be subject to income tax — on an "income-first"
basis — to the extent your cash surrender value exceeds your investment in the
contract. The taxable portion of your withdrawal may also be subject to a 10%
early distribution penalty if you haven't reached age 59½, unless an exception
A second distribution option is called
the guaranteed income (or annuitization) option. If you select this option,
your annuity will be "annuitized," which means that the current value of your
annuity is converted into a stream of payments. This allows you to receive a
guaranteed income stream from the annuity. The annuity issuer promises to pay
you an amount of money on a periodic basis (e.g., monthly, yearly, etc).*
If you elect to annuitize, the periodic payments you receive are called annuity
payouts. You can elect to receive either a fixed amount for each payment period
or a variable amount for each period. You can receive the income stream for your
entire lifetime (no matter how long you live), or you can receive the income
stream for a specific time period (ten years, for example). You can also elect
to receive annuity payouts over your lifetime and the lifetime of another person
(called a "joint and survivor annuity"). The amount you receive for each payment
period will depend on the cash value of the annuity, how earnings are credited
to your account (whether fixed or variable), and the age at which you begin
receiving annuity payments. The length of the distribution period will also
affect how much you receive. For example, if you are 65 years old and elect to
receive annuity payments over your entire lifetime, the amount of each payment
you'll receive will be less than if you had elected to receive annuity payouts
over five years.
Each annuity payment is part nontaxable return of your investment in the contract
and part payment of taxable accumulated earnings (until the investment in the
contract is exhausted).
1"Is the 4 Percent Rule Too Low or Too High?" Journal of Financial Planning, onefpa.org, 2019
2Indivdiuals who reached age 70½ in 2019 must begin taking RMDs by April 1, 2020, unless they are still working for the company sponsoring the plan.