The higher your
the more you'll
have to consider
whether it is
the long term.
RMDs are calculated
by dividing your
traditional IRA or
account balance by a
life expectancy factor
specified in IRS tables.
Your account balance
is usually calculated
as of December 31 of
the year preceding the
calendar year for
which the distribution
is required to be made.
Making Portfolio Withdrawals
When planning for retirement income, you'll need to determine your portfolio withdrawal
rate, decide which retirement accounts to tap first, and consider the impact of
required minimum distributions.
Your retirement lifestyle will depend not only on your asset allocation 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 the principal itself,
is known as your withdrawal rate.
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;
how your portfolio is structured then and how much you take out can have a significant
impact on how long your savings will last.
What's the right number? It depends on your overall asset allocation, projected
inflation rate and market performance, as well as countless other factors, including
the time frame that you want to plan for. For many, though, there's a basic assumption
that an appropriate withdrawal rate falls in the 4% to 5% range. In other words,
you're withdrawing just a small percentage of your investment portfolio each year. To understand why withdrawal rates generally
aren't higher, it's essential to think about how inflation can affect your retirement
Consider the following example: Ignoring taxes for the sake of simplicity, if a
$1 million portfolio earns 5% each year, it provides
$50,000 of annual income. But if annual inflation pushes prices up by 3%, more income — $51,500 — would
be needed the following year to preserve purchasing power. Since the account provides
only $50,000 income, an additional $1,500 must be withdrawn from the principal to
meet expenses. That principal reduction, in turn, reduces the portfolio's ability
to produce income the following year. As this process continues, principal reductions
accelerate, ultimately resulting in a zero portfolio balance after 25 to 27 years,
depending on the timing of the withdrawals.
When setting an initial withdrawal rate, it's important to take a portfolio's potential
ups and downs into account — and the need for a relatively predictable income stream
in retirement isn't the only reason. If it becomes necessary during market downturns
to sell some securities in order to continue to meet a fixed withdrawal rate, selling
at an inopportune time could affect a portfolio's ability to generate future income.
Also, making your portfolio either more aggressive or more conservative will affect
its life span. A more aggressive portfolio may produce higher returns, but might
also be subject to a higher degree of loss. A more conservative portfolio might
produce steadier returns at a lower rate, but could lose purchasing power to inflation.
Tapping tax-advantaged accounts — first or last?
You may have assets in accounts that are tax deferred (e.g., traditional IRAs) and
tax free (e.g., Roth IRAs), as well as taxable accounts. Given a choice, which type
of account should you withdraw from first?
If you don't care about leaving an estate to beneficiaries, consider withdrawing
money from taxable accounts first, then tax-deferred accounts, and lastly, any tax-free
accounts. The idea is that, 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 on a tax-deferred basis.
If you're concerned about leaving assets to beneficiaries, however, the analysis
is a little more complicated. You'll need to coordinate your retirement planning
with your estate plan. For example, if you have appreciated or rapidly appreciating
assets, it may make sense for you to withdraw those assets from your tax-deferred
and tax-free accounts first. The reason? These accounts will not receive a step-up
in basis at your death, as many of your other assets will.
But this may not always be the best strategy. For example, if you intend to leave
estate to your spouse, it may make sense to withdraw from taxable accounts first.
This is because your spouse is given preferential tax treatment when it comes to
your retirement plan. Your surviving spouse can roll over retirement plan funds
to his or her own IRA or retirement plan, or, in some cases, may continue the plan
as his or her own. The funds in the plan continue to grow tax deferred, and distributions
need not begin until after your spouse reaches age 73. The bottom line is
that this decision is also a complicated one, and needs to be looked at closely.
Required minimum distributions (RMDs)
Your choice of which assets to draw on 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 73, whether you need the money or not. For employer plans, RMDs must begin
by April 1 of the year following the year you turn 73, or, if later, the year
you retire. Roth IRAs aren't subject to the lifetime RMD rules (beneficiaries will be required to take RMDs from Roth IRAs).
If you have more than one IRA, a required distribution amount is calculated separately
for each IRA. These amounts are then added together to determine your total RMD
for the year. You can withdraw your RMD from any one or more of your IRAs. [Similar rules apply to Section 403(b) accounts.] 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
It's very 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 25% of the amount you failed to withdraw (a timely correction could reduce the tax to 10%). The good news: You
can always withdraw more than your RMD amount.