Converting Savings to Retirement Income

By Laurie Haelen

Congratulations, you have made it to retirement!

During your working years, you’ve probably set aside funds in retirement accounts such as IRAs, 401(k)s or other workplace savings plans, as well as in taxable accounts (i.e., brokerage or bank accounts).

During retirement, it is likely you will need to convert those savings into an ongoing income stream that will last throughout your retirement years, as a compliment to Social Security or any pensions you may have.

In other words, after many years of receiving a paycheck, you will have to create one for yourself during your retirement.

The retirement lifestyle you can afford will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from returns or both returns and principal, is known as your withdrawal rate.

Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents some challenges. If you take out too much too soon, you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could. Your withdrawal rate is especially important in the early years of your retirement, as it will have a lasting impact on how long your savings last.

One widely used guideline on withdrawal rates for tax-deferred retirement accounts that emerged in the 1990s stated that withdrawing slightly more than 4% annually from a balanced portfolio of large-cap equities and bonds would provide inflation-adjusted income for at least 30 years. However, more recent studies have found that this guideline may be too generalized. Individuals may not be able to sustain a 4% withdrawal rate or may even be able to support a higher rate, depending on their individual circumstances.

The bottom line is that there is no standard guideline that works for everyone — your withdrawal rate needs to consider many factors, including, but not limited to, your asset allocation and projected rate of return, annual income targets (accounting for inflation as desired), investment horizon, and life expectancy, according to “The State of Retirement Income: Safe Withdrawal Rates,” published in 2021 by Morningstar.

Taxes are also an important consideration. You may have assets in accounts that are taxable (e.g., CDs, mutual funds), tax deferred (e.g., traditional IRAs), and tax free (e.g., Roth IRAs). Given a choice, which type of account should you withdraw from first? The answer is — it depends.

For retirees who don’t care about leaving an estate to beneficiaries, the answer is simple in theory: withdraw money from taxable accounts first, then tax-deferred accounts, and lastly, tax-free accounts. By using your tax-favored accounts last, and avoiding taxes as long as possible, you’ll keep more of your retirement dollars working for you.

For retirees who intend to leave assets to beneficiaries, the analysis is more complicated. You need to coordinate your retirement planning with your estate plan. For example, if you have appreciated or rapidly appreciating assets, it may be more advantageous for you to withdraw from tax-deferred and tax-free accounts first. This is because these accounts will not receive a step-up in basis at your death, as many of your other assets will.

However, this may not always be the best strategy. For example, if you intend to leave your entire estate to your spouse, it may make sense to withdraw from taxable accounts first. This is because spouses are given preferential tax treatment regarding retirement plans. A surviving spouse can roll over retirement plan funds to his or her own IRA or retirement plan or, in some cases, may continue the deceased spouse’s plan as his or her own. The funds in the plan continue to grow tax deferred, and distributions need not begin until the spouse’s own required beginning date.

The bottom line is that this decision is also a complicated one. A financial professional can help you determine the best course based on your individual circumstances.

In practice, your choice of which assets to draw first may, to some extent, be directed by tax rules. You can’t keep your money in tax-deferred retirement accounts forever. The law requires you to start taking distributions — called required minimum distributions or RMDs — from traditional IRAs by April 1 of the year following the year you turn age 73 (for those who reach age 72 after Dec. 31, 2022), whether you need the money or not.

For employer plans, RMDs must begin by April 1 of the year following the year you turn 73 or, if later, the year you retire. Roth IRAs aren’t subject to the lifetime RMD rules. (Beneficiaries of either type of IRA are subject to different distribution rules.)

If you have more than one IRA, a required distribution is calculated separately for each IRA. These amounts are then added together to determine your RMD for the year. You can withdraw your RMD from any one or more of your IRAs. (Your traditional IRA trustee or custodian must tell you how much you’re required to take out each year or offer to calculate it for you.) For employer retirement plans, your plan will calculate the RMD and distribute it to you. (If you participate in more than one employer plan, your RMD will be determined separately for each plan.)

It’s important to take RMDs into account when contemplating how you’ll withdraw money from your savings. Why? If you withdraw less than your RMD, you will pay a penalty tax equal to 50% of the amount you failed to withdraw. The good news: You can always withdraw more than your RMD amount.

This is a complex topic and I have listed here some of the considerations in creating a successful retirement income strategy.

As always, I recommend involving a financial professional when feasible to ensure your strategy is effective and will carry you safely—and ideally happily—through your retirement years.