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Picture this: You worked hard your entire life, saving diligently for retirement. At 65, you were living the dream. At 75, you enjoyed a comfortable -- if not luxurious -- lifestyle. But at age 85, you seemed to inexplicably run out of money.
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How did the ship sink so quickly? There was an iceberg, barely visible above the water but monstrous beneath the surface, in the form of mismanaged distributions and ill-conceived budgeting.
Most investors find it difficult to convert their account balances to an income stream once they're retired. The goal is to make sure you don't outlive your assets, but how? Just as a poor distribution strategy (or none at all) can be a disaster waiting to happen, a good distribution strategy can help illuminate a better path through retirement.
Consider these tips when developing your own plan so you don't spend too much or too little in retirement
Step One: Consider the three phases of retirementFinancial habits evolve over time. While you may have calculated the longevity of your nest egg in terms of annual retirement income, your spending will probably change dramatically as you move further into retirement.
The average retiree can expect three phases of retirement:
- Early retirement: a period of travel, hobbies, and adventure
- Middle retirement: a stage marked by socializing, activity, and relaxation
- Later retirement: a time of winding down, when most of your days are spent at home
It's logical to assume the costs of retirement will vary from phase to phase. Spending habits at age 50 are definitely not the same as they were at 30. Likewise, your spending at age 85 will look different from your spending at age 65. Therefore a distribution strategy that includes specific "buckets" of money for each phase makes the most sense and will help ensure that you won't outlive your nest egg.
Step Two: Nail down a plan for Social SecurityOptimizing Social Security and other guaranteed sources of retirement income, such as pensions, is hugely important so that you're able to withdraw as little as possible from your other retirement accounts.
There are two logical approaches. You could aim to start collecting Social Security benefits as soon as you are able, which would lessen the need to draw from your other sources of retirement income -- like Individual Retirement Accounts (IRAs) or a 401(k) -- in your early retirement years. Alternatively, you could delay Social Security in order to secure a higher monthly benefit, making Social Security a more significant source of income later in life.
What's right for you depends on various factors, including your income needs and estimated life expectancy.
Step Three: Decide when to be taxedTax treatment of your distributions will differ based on account type. Withdrawals from traditional IRAs, traditional 401(k)s, and brokerage accounts are taxable when distributed. For Roth IRAs and Roth 401(k)s, withdrawals are tax-free if it's been at least five years after you first funded the account and you've reached age 59-1/2.
Your distribution strategy should outline which accounts you will draw from first, especially if you have both traditional and Roth monies at your disposal. Your options include:
- Draw all income from your traditional accounts first, leaving your Roth accounts for last -- which allows you to minimize or altogether avoid income taxes later in retirement.
- Take distributions from your Roth accounts first, paying no income taxes on that money. You might prefer this option if you plan to spend a lot of money during early retirement, as it could allow you to make larger tax-free withdrawals during high-spending years. As your income needs are likely to lessen later in retirement, you might benefit from lower taxes on smaller withdrawals from your remaining traditional accounts.
- Use a blended approach -- in other words, take distributions from both your traditional and Roth accounts to diversify your tax treatment.
Step Four: Plan ahead for required minimum distributionsA required minimum distribution is the minimum amount anyone over the age of 70-1/2 is required to withdraw annually from their retirement accounts. For 401(k)s and 403(b)s, RMDs can sometimes (depending on plan rules) be delayed until you retire. For traditional IRAs, you must begin taking RMDs once you turn 70-1/2 regardless of whether you are still working.However, RMD rules do not apply to Roth IRAs while the original account owner is alive (though they come into play with inherited Roth IRAs).
Your plan custodian or administrator can usually help calculate your RMD, but it's ultimately up to you to ensure that you withdraw the correct amount each year by the deadline (typically Dec. 31) so as to avoid stiff IRS penalties.
These are big and complicated decisions, and what we've touched on here is just the beginning. You might consider consulting a tax professional prior to making these decisions. Your investment advisor should work in concert with your CPA (certified public accountant) to determine a withdrawal strategy that makes the most sense tax-wise.
The article 4 Tips for Retirement Distributions originally appeared on Fool.com.
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