Let's say everything goes fine, or as well as can be expected, and you enter retirement with a nice, plump nest egg.
Now that it’s time to start taking money out, where should you start if you have a variety of assets and accounts?
First, consider the basic asset types: stocks, bonds, cash and your home. As a general rule, you don’t want to rely on stocks or stock funds to pay for the week’s groceries. If you do, withdrawing a set amount every week could do a lot of damage when stock prices are down.
So the basic idea is to pay for ongoing expenses out of a cash account, such as a checking or money market account that is large enough for six to 12 months’ expenses. From time to time you can replenish the cash account, ideally from a relatively stable source like a bond or certificate of deposit that has matured, or from a bond fund.
Then, when conditions are right, you can draw from stocks or stock funds to top off the bond holdings, which ideally should be large enough to cover at least five years’ expenses. If stocks are down, you could postpone that move. If they are up, you can do it ahead of schedule. Using the bond and CD holdings as a buffer between cash and stocks can help you avoid having to sell stocks in a down market.
Deciding which type of account to draw from involves a look at tax issues. Most financial advisers recommend drawing from ordinary taxable accounts first. That allows tax-favored accounts like 401(k)s and IRAs to continue growing as long as possible.
Also, some of your holdings in taxable accounts may be subject to long-term capital gains rates, currently taxed no higher than 15%. Your 401(k) and traditional IRA holdings will be subject to income taxes, at rates as high as 35%. It pays to postpone those higher tax bills for as long as possible.
After you’ve gone through the taxable accounts, turn to the 401(k) and traditional IRAs. Once you’ve emptied those, start tapping any Roth IRAs or Roth 401(k)s. Because withdrawals from these are tax-free, it makes sense to leave them fully funded for as long as possible, to get the most tax-free growth you can.
Finally, tap the equity in your home. Refinancing or taking out a home-equity loan is generally not possible if you don’t have income, which you won’t if you are retired and have depleted your other investments.
So, to turn your home into cash you’ll have to sell it or take out a reverse mortgage. That’s a loan that requires no payments and allows you to stay in the home as long as you want. The loan and accumulated interest are paid from the proceeds after the home is sold, and are not due until then even if you keep the property for decades until you die. Also, the debt can never exceed the property’s sales price. This makes the reverse mortgage suitable as a last-ditch financial resource.
There is a downside, however. With a reverse mortgage you cannot borrow as much as your property is worth. The younger you are, the less you can get.
Are there any exceptions to the standard order of withdrawal guidelines? Yes, you might want to tinker with them if you expect your tax bracket to change significantly. If you believed your tax bracket would rise in the future, for example, it might pay to take money from the 401(k) and traditional IRA, so you could pay at the lower rate to avoid a higher rate later.
Generally, though, the standard rules should serve most retirees most of the time.
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