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Making Sensible Withdrawal Choices

A successful retirement income plan requires investors to pay careful attention to their withdrawal strategy.

A good deal of off-the-shelf retirement advice concentrates on determining how much an investor will need when he retires, but neglects the question of how to put those assets to use. In the end, having a well-considered plan for your retirement withdrawals may help safeguard and extend the lifespan of your nest egg.

A Five-Year Plan as Your Foundation

Much recent research has debunked the notion that retirement portfolios must be conservatively positioned. Indeed, given longer average life expectancies, a significant exposure to equities may be essential to help assure that you do not outlive your retirement income stream. But at the same time, the fact remains that your retirement account will likely represent a key source of income, and it should be treated with great care.

Financial planners have attempted to balance these seemingly contradictory impulses by encouraging retirees to keep a "cash reserve" large enough to cover five years of expenses. Five-year plans may have the twofold benefit of protecting near-term income while providing a conservative core which may help reduce portfolio volatility. Additionally, adopting such a reserve approach may allow you to liquidate your investments gradually, rather than having to sell assets (perhaps at inopportune times) to meet immediate income needs.

A carefully considered retirement budget is an essential prerequisite for this type of planning. To determine this, make a detailed list of each year's expenses for the next five years (remembering to adjust for inflation) and subtract any regular income you may receive from Social Security, pensions, annuities, or other sources. The amount that remains will represent the size of your five-year cushion. Be sure to consider very conservative vehicles for these assets, such as money market or short-term bond funds.

Asset Longevity by Investment Vehicle

Taking Care of the Order

Very likely, your retirement portfolio incorporates many different investment vehicles, including both tax-deferred accounts (such as Traditional and Roth individual retirement accounts) as well as taxable accounts. Because of this, you will have to make decisions about which accounts to tap for income, and the decisions you make can affect the longevity of your savings.

When it comes to choosing a withdrawal strategy, there are two general guidelines to consider:

  • Tap taxable investments first. Investments outside tax-deferred accounts may generate income or distribute capital gains on an ongoing basis, and the taxes you pay on these distributions can reduce your net return. In contrast, investments in tax-deferred accounts such as IRAs can compound free from current taxes, which may increase your potential long-term returns and thus increase your investment longevity as well.1
  • Tap Traditional IRAs before Roth IRAs. Your assets will grow tax-deferred as long as they remain in a Traditional IRA, but the withdrawals you make may be subject to income taxes. In contrast, qualified retirement withdrawals from a Roth IRA are tax free. Because of this, a Roth IRA may be able to generate an income stream for a longer period than a similarly invested Traditional IRA and should therefore be left untapped for as long as possible.

Your Individual Approach

When it comes to retirement income planning, there are few hard-and-fast rules which everyone must follow; instead, it is vitally important that your decisions reflect your own financial situation. Those in high income brackets, for instance, may find that taking withdrawals from taxable, capital gains-oriented investments results in a lower tax bill than tapping Traditional IRAs; lower-income retirees may need to reduce their tax bill to make ends meet, and decide to tap their Roth IRAs first. Retirees with a high risk tolerance may find a three-year income cushion more appropriate than a five-year cash reserve, while those with low tolerance may prefer a seven-year cushion.

Whatever course you adopt, be sure that it is appropriate for your circumstances, and that it keeps the long-term health of your retirement income stream uppermost in mind.

It's best to talk with your financial advisor about your individual situation. If you don't already have one, call us at 1-800-896-2645 for assistance.

1. The IRS has prescribed required minimum distribution requirements for IRAs that may require you to make withdrawals from IRAs before you might otherwise choose to do so using this strategy. Please consult your tax adviser for more information.