Many people plan, save, and invest so they can live comfortably when they stop working. Once they reach retirement age, they face a new set of challenges: How to manage the money they’ve accumulated and the new sources of income they will live on.
Even though people generally spend less in retirement, financial planners say they’ll still need roughly 80% of the income they had while working. For someone who made $75,000 a year, that would be $60,000 a year. Future retirees have a number of different ways to increase the odds that they have the necessary income stream after they stop working.
Retirement income strategies
Social security and investment income are two of the most common income strategies for retirees.
The big reason retirees need to save so much is because federal Social Security benefits are unlikely to cover a person’s expenses once they stop working. The Social Security Administration estimates the monthly award will equal only about 40% of an individual’s pre-retirement income—and this may be an underestimate.
The monthly Social Security check a person receives is determined by their age, birth year, how many years they’ve worked, and how much money they earned. The calculation considers the recipient’s lifetime earnings over their top-earning 35 years.
Individuals born from 1943 to 1954:
- Full Social Security retirement benefits begin at age 66.
- Workers can start receiving their payments at age 62, but they’ll get just 75% of their benefit at age 62.
- Waiting until age 70 to start accessing benefits will yield 132% of the amount.
Individuals born between 1955 and 1960:
- The age for eligibility to receive full benefits increases by a couple of months each year; full retirement age tops out at age 67.
- Waiting until age 70 to start receiving benefits will yield 124% to 132% of the amount, depending on birth year.
Individuals born in 1960 or later:
- Full Social Security retirement benefits begin at age 67.
- Workers can start receiving their payments at age 62, but they’ll get just 70% of the full amount.
- Waiting until age 70 to start accessing benefits will yield 124% of the amount.
There is no hard and fast rule for when a retiree should start collecting Social Security. Health, longevity, finances, marital status, work opportunities, willingness to downsize, and a host of personal issues specific to the individual’s situation factor into the equation. The Social Security Administration addresses frequently asked questions to help people decide on timing.
Note: People must have a minimum of 10 years in the workforce to be eligible for Social Security.
Social Security is just one piece of the retirement money equation. IRAs, 401(k)s, bank accounts, investments, stocks, bonds, and other assets all figure into a retiree’s potential income mix and strategy for managing the funds. Once a person retires, they need to devote as much thought to withdrawing the money as they did to saving it in the first place.
There are several approaches retirees often use to help manage their retirement dollars. They are:
Bucketing based on time
- The first few years. This money is kept in cash or cash equivalents, in easily accessible accounts such as high-yield bank accounts and short-term certificates of deposit.
- The next three to 10 years. Investments include fixed-income securities with predictable returns, such as bonds or longer-term CDs. When the first bucket runs low, the retiree can sell from the second bucket to replenish the waning funds.
- 10 years and onward. This bucket is designed for growth. The retiree invests the money they won’t need for a decade or more. The funds go mainly into the stock market, where annual returns have historically averaged about 10%.
Bucketing covers all of a retiree’s bases. They have cash for normal expenses and unplanned events; they have investments that generate reliable returns; and they have an avenue that can bring big gains to help beat inflation and keep the buckets from emptying out. The buckets can be rebalanced if income needs or risk tolerance changes.
The approach does have risks. Retirees must accurately gauge their spending and withdrawal timing upfront so the system works as designed. And of course, there’s no guarantee that the investments will perform as expected because of changing market conditions.
Systematic withdrawal following the 4% rule
Retirees who want to put all of their nest eggs into one basket may opt for the 4% strategy. This approach seeks to deliver both a steady income stream and an account balance that will support that stream throughout retirement.
The retiree sets up a diversified portfolio that covers all asset classes. They then withdraw an amount equal to 4% of the assets in the first year, which would be increased in the coming years to make inflation adjustments. So, for example, if a retiree has a nest egg of $1 million, they would withdraw $40,000 in the first year. In the second year, assuming an inflation rate of 2%, they would withdraw $40,800.
The 4% strategy has several caveats. It assumes the investment portfolio contains about 50% stocks and 50% bonds. It also assumes that the retiree will hold their spending to the prescribed level throughout retirement.
However, spending patterns can and do change during retirement. A person’s longevity also affects how long the funds will last. If the portfolio takes a big hit, the retiree may have to scale back their withdrawal rate so their money lasts as long as they do.
Essential vs. discretionary
The essential-versus-discretionary spending approach contains elements of the bucket and the 4% strategies.
The retiree divides their expenses into two categories:
- Essential items. These include housing, food, clothing, medical bills, and other requirements of daily life.
- Discretionary items. This includes money for things like vacations, entertainment, and gifts.
The individual places a portion of their retirement savings into low-risk investments to cover essential expenses. They may choose to buy an income annuity or create a bond or CD ladder, a collection of assets with differing maturity dates that deliver continuous income streams. These investments, along with any Social Security or pension benefits, provide an income floor. The rest of the savings are invested in a diversified portfolio to provide for discretionary spending.
This strategy can have several drawbacks. Research shows that retirees generally underestimate their essential needs. Once retired, a person’s definition of essential and discretionary often changes. A diversified portfolio, meanwhile, may not deliver the money needed for a vacation or a new car.
Planning for RMDs
Once it’s time to draw from money saved in a retirement account, it’s crucial to understand the regulations covering withdrawals and to adopt the most advantageous sequence for spending down the nest egg.
Required minimum distributions (RMDs) from tax-advantaged retirement accounts probably will be the centerpiece of a retiree’s withdrawal thinking. The Internal Revenue Service requires individuals to begin taking money from each of these accounts at age 72 and every year after. These accounts include all the big retirement savings vehicles: 401(k)s, IRAs, profit-sharing plans, and other defined-contribution plans. (Roth IRAs and 401(k)s, accounts that allow tax-free withdrawals, are exempt when held by the original owner.)
Failure to take the full RMD at the right time results in a 50% penalty on the amount the retiree did not receive.
The RMD distribution amount is based on a person’s life expectancy and changes each year. The retiree divides each account’s year-end value by the anticipated remaining years of life. The IRS provides a table and worksheets to help retirees calculate their distributions.
Keeping the RMD requirements in mind, a financial advisor may recommend the sequence below to maximize income in retirement:
- Spend first from taxable accounts, allowing those with tax benefits to grow.
- Withdraw from tax-deferred accounts such as traditional IRAs and 401(k)s.
- Draw last from tax-free accounts such as Roth IRAs and 401(k)s.
Retirees must include withdrawals from tax-deferred accounts in their taxable income. They pay no taxes on withdrawals from Roth accounts.
When some seniors add their prescribed RMDs to their Social Security benefit and gains from investments and other retirement income sources, they may wind up with more income—and a higher marginal tax bracket—than they expected.
The bottom line
The retirement savings a person earns and invests during their working years are meant to carry them through the rest of their life. Successfully managing this nest egg requires understanding the guidelines for claiming Social Security benefits and the rules for taking RMDs from retirement-savings plans.
Savings buckets, systematic withdrawals, and determining what’s essential versus discretionary are among the strategies for maximizing income in the senior years.