money jar

By Arthur S. Rothschild

One of the first questions we hear from individuals planning the end of their working years is how much they can afford to spend in retirement. A big part of the answer involves their ability to spend some percentage of their investment portfolios.

The rate can vary with investment returns, inflationary expectations, investment yields and so forth, but a good starting point today, for an appropriately invested portfolio might be a distribution rate of 4%.

For example, assuming you have accumulated a portfolio of $500,000, at 4%, you could spend $20,000 in that first year of retirement.

We suggest that the starting level could be increased in a year by an assumed inflation rate: 2% might be a reasonable assumption today. So, in this example, the distribution would increase by 2% to $20,400 in the second year of this retirement plan.

Random Monte Carlo assumptions going back to the 1920s have shown that a 4.2% initial withdrawal rate with an annual increase for inflation has a 95% success rate.

Further resources
The Internal Revenue Service explains requirements for annual withdrawals from retirement accounts for account holders older than 70½.

required minimum distribution calculator for determining retirement account withdrawals, from the Financial Industry Regulatory Authority

But that assumes you never change your withdrawal strategy. You could support a withdrawal rate of 5% or more by withdrawing more from the stock side of your portfolio in years when the market is up 10% or more and then leaning more on the bond side when the market falls 10% or more.

For most investors, at a time of historically low interest rates, we are comfortable recommending a 4% initial rate with a 2% annual cost-of-living adjustment.

Because we don’t want to have someone’s investment spending be determined by their investment results, we make sure they have enough set aside in relatively safe assets so they can spend over an eight- to 10-year period – regardless of what happens in the markets. That typically involves having a minimum of 35% of their accounts laddered in fixed-income investments.

We’ll want to take the distributions from the least-volatile assets that the clients have. That way, we can allow those assets that are the most volatile to continue to grow.

And bear in mind that the investment portfolio is only one leg of the retirement stool. Others include:

  • Pensions
  • Social Security
  • Other sources of potential income, such as investment real estate

We integrate portfolio distributions into the process of planning for pension payments and the timing of when to start taking distributions from Social Security.

Tax planning also factors in. We plan based on retirees’ spending needs and the assets they have available and attempt to optimize their tax situation.

Early on, we can take money out of accounts that were funded with after-tax dollars and are not taxed again on distribution. That way, we might be able to have a tax holiday for a number of years, until age 70½, when clients have to start taking money out of tax-deferred accounts, such as 401(k) s and IRAs.

For some clients, 4% distributions from their portfolio might not be enough to sustain their lifestyle in retirement. For those individuals, we discuss the pros and cons of higher distributions rates so they can go into retirement with a realistic plan.

Arthur S. Rothschild, J.D., CPA, CFP, is a vice president at Landaas & Company. Contributing: Joel Dresang.

(initially posted Dec. 18, 2014)

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