You've probably heard how important it is to save money for retirement at least a thousand times. However, saving money is only half the story -- if you don't know how to make your money last once you've retired and are spending it, you could potentially run out of money in mid-retirement.
Building capital vs. building income
While you're working and saving money in your retirement accounts, your focus is on building capital. Once you retire, your focus must shift toward preserving capital and building income instead. That's an entirely different mindset, and it requires you to play by different rules than the ones you've been using up until now. To make matters more complicated, the rules can change depending on the economy, the market, and other factors.
For example, experts have long argued that by the time you reach retirement age, your investments should be entirely or almost entirely in bonds rather than stocks. However, if interest rates are extremely low, as they have been for several years now, bonds may not provide enough of a return to allow your retirement savings to last for the rest of your life -- especially since retirees are living longer than ever.
If you're approaching retirement in a low interest rate environment, consider keeping a significant percentage of your investments in stocks rather than switching them all over to bonds. Some experts now recommend subtracting your age from 110 or 120 and keeping that percentage of investments in stocks, with the rest in bonds. So, if you retire at age 70, you'd want to have 40%-50% of your portfolio in stocks and the rest in bonds.
The 4% rule
Another important factor to consider is the percentage of total capital you can safely withdraw from your retirement accounts each year without eventually running out of money. Since the early 1990s, most experts have cited the rule of thumb that if you withdraw 4.5% of the balance in your retirement accounts each year, your accounts will last you at least 30 years.
Unfortunately, that rule is no longer as clear-cut as it once was. If you retire at 60 or 65, it's entirely possible that you'll live longer than 30 years in retirement. There's also evidence that in a low interest rate environment, 4.5% is too high and will cause your funds to run out well before the 30-year mark. Third, this rule doesn't take into account whether or not you want to leave part of your savings for your family or other beneficiaries to inherit.
The vehicle(s) you choose for your retirement accounts can also have a big effect on how much income you get out of them, simply because some sources of income will be taxed, others won't be, and still others will be taxed, but at a different rate. In brief, distributions from traditional IRAs and 401(k)s will be taxed as income, distributions from ROTH accounts will not be taxed, Social Security benefits may or may not be taxed depending on your overall income level, and investments that you hold in non-retirement brokerage accounts may be charged capital gains tax when you sell them.
Ideally, you should have money tucked away in a wide range of retirement vehicles. That gives you several options for pulling the income you need, allowing you to choose the source that gives you the best tax outcome.
Consider delaying your retirement
By the time you hit age 65, you'll probably be eager to kick back, relax, and leave the working world for good. However, if you can hold out till age 70, you'll greatly increase your odds of staying fully funded throughout your retirement.
Delaying your retirement gives you additional years to contribute to your retirement accounts and let them grow. On top of that, if you wait until age 70 to start collecting Social Security benefits, your benefit amount will go up significantly. If you were born after 1943, your Social Security benefits will increase by 8% for each year that you wait to claim your benefits past normal retirement age. Once you hit 70, these delayed retirement credits quit accruing, so there's no point in waiting longer than that to tap your benefits.
Know your RMDs
Once you reach age 70 1/2, the IRS requires you to start taking distributions from your tax-deferred retirement accounts. This includes all flavors of workplace retirement accounts (401(k)s, 403(b)s, etc.) and IRAs, except for ROTH accounts. It's important to understand this concept before you hit 70 1/2 so you can take required minimum distributions (RMDs) into consideration when doing your retirement planning.
The IRS website has worksheets and tables you can use to estimate your required minimum distribution, and there are also online calculators that will do the math for you. RMDs are based on how much money you have in your tax-deferred accounts, which is yet another compelling reason to spread your retirement savings out over several different kinds of accounts.
Your RMDs will have several effects on your finances during retirement. First, since RMDs come out of tax-deferred accounts, this income will be taxable the year you take it. As a result, RMDs can have a noticeable impact on your tax bracket and on related considerations, such as whether or not you are subject to capital gains tax.
Second, RMDs can take a significant bite out of your capital, especially during the first few years, when your RMD will be largest. You may have to take special care planning your investments in those years to keep your accounts from shrinking too much. And finally, you have to take the RMD whether or not you need that much income. Thus, it's wise to take the distribution as early in the year as possible so that you can wait to draw other, non-mandatory sources of income until you really need them.
Seek professional help
Even an experienced do-it-yourself investor would be wise to consult a financial professional before officially retiring, and also periodically during retirement. Because there are so many factors involved in maximizing your retirement funds, it takes an expert to keep track of them all. And because interest rates, tax rates, and laws affecting taxes and investments can change at any time, the best money management strategy today may differ from the best strategy five years from now.
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