There’s a lot of talk about how to best save up for retirement: when to start, how much to put away, what sort of accounts and investment vehicles to use, how to minimize your tax burden… the list goes on and on. That last topic, in fact, is precisely what the first part of this post dealt with (be sure to catch up with that one before reading this. We’ll still be here).
All this coverage on retirement saving makes a lot of sense, of course. But the other side of the equation, while just as important, doesn’t get nearly as much attention – namely, how to do your retirement spending.
When people do think about this question, it’s usually just in terms of how to budget so they don’t… you know… run out of money. There’s a lot more to it than that, however. Don’t get me wrong, not-running-out-of-money is definitely important. But good financial planning is about more than just avoiding mishaps: it’s really about maximizing your benefit.
In the last post, we talked about how to maximize the benefit of your retirement saving – that is, how to do it as efficiently and profitably as possible. Today, the question is how to spend those savings as efficiently as possible. The key is to carefully plan your sequence of withdrawals – that is, the order in which you spend your various investments and in what amounts.
Saving while you spend: the compounding interest problem
At the risk of stating the obvious, the thing about savings or investment accounts is that, unlike spending or checking accounts, they feature compounding interest. That is, they grow by a small percentage of their total value over time, and this change gradually accelerates as the balance of the account increases.
This rate of growth – also known as the rate of return, or RoR – may or may not be fixed. In fact, if it’s heavily influenced by stock market performance, it will probably even end up negative sometimes. Regardless of what your RoR looks like, the main thing is to recognize that your retirement savings accounts are always changing in some way or another, without any input from you.
For example: if you start with $100 in an account that grows 5% annually, and don’t touch it for a year, then you’ll have $105 at the end of that year. And if you leave it alone for another year, then that new total of $105 will generate interest of 5% – but now 5% means $5.25, rather than just $5. So you end up with a total of $110.25 after year 2, then $115.76 after year 3, and so on.
You may very well know how this works already, but here’s the crucial thing to keep in mind: this flux in your investments doesn’t stop once you start withdrawing from them. They keep accruing interest, regardless of whether you’re in the saving or spending stage.
People tend to think of interest as only accruing when an account is unused – which can prove to be a very costly mistake. The bigger the overall balance you’re working with (and/or the more time is allowed to elapse), then the more dramatic the compounding effects will be.
Consider a starting balance of $1,000,000 that grows 5% annually:
After five years, this account has already accumulated the equivalent of a middle-class annual salary all on its own – even while its owner is withdrawing $40k or more every year. Yow!
This all goes to show that the timing of your withdrawals can have a major effect on the future value of your remaining balance. Any different configuration of withdrawals in the above example would have produced markedly different results at the end of five years. And if you have multiple investments contributing to your total balance, each with its own interest rate, then that complicates the possibilities even further.
So this is where it’s important to consider your sequence of withdrawals. But what does that entail?
Factors to consider in a sequence of withdrawals
There are a number of things at play here, more than we can fit in just this post. But regardless of which variables you’re focused on, the first step in making a sequence of withdrawals is to map out what your financial goals are throughout your retirement, and then try to allocate your savings accordingly.
Again, what you spend and when can have a major impact on the total amount you have to work with over time. Also, your income needs are unlikely to remain consistent throughout the whole span of your retirement. It’s important to keep both of these facts in mind.
Below is an example of what this first step could look like: some bigger outlays in the first five years, slowly tapering down over the second decade, with plenty left over after year 20 – a good chunk of which, hopefully, will be left to your heirs.
So – if this pie chart represents the ideal distribution of your savings, how do you achieve that?
First, there’s the nuts and bolts of your specific income requirements. Let’s put things in less math-y terms: suppose one specific goal you have is to move closer to your kids within five years of retiring. And let’s say they live in a more expensive metropolitan area than you currently do. In all likelihood, then, your expenses will be rather front-loaded in those first five years.
Let’s also say that you have both a Roth IRA and a 401(k), though the balance of the latter is substantially bigger than that of the former. Perhaps your first thought is that your upcoming move should be largely funded by 401(k) income – after all, it just feels safer for big expenses to come from the bigger account, right?
Well, it might not be that simple. Consider a second important factor: the different rates of return across your savings and holdings. RoR is a really big can of worms – one that we’ll dig into more in next week’s post – but it’s worth mentioning here.
Let’s say your 401(k) has historically kept a pretty steady rate of return around 6%, while your more volatile IRA has had a bad year, wavering between 3-4% with no immediate signs of really perking up. Perhaps this gives you reason to use the IRA instead, spending it down and therefore cutting your losses before things get worse?
And there’s a third, more obvious wrinkle in the plan: the distinction between taxable, tax-deferred and tax-free accounts. This is just as important on the spending side of retirement as it was on the saving side. 401(k) withdrawals are taxable, while those from a Roth are not. So in the current example, perhaps it makes more sense to draw down the Roth first – that way your beefier 401(k) can keep up its momentum for a while, before you start spending it and exposing it to tax.
Oof. It’s a lot to think about.
Pro-rata versus sequential withdrawals
If all this juggling of yearly withdrawal amounts, timeframes and RoR is making your head spin, then I have some good news. There is a simpler approach, albeit one that will probably leave some tax savings on the table… but that’s arguably the point.
I’m referring to the pro rata withdrawal strategy, which has you withdraw proportional amounts from all your accounts and/or holdings at once, rather than parceling out their distribution over time. So, for example, if you have an account that is 60% one high-yield asset, and 40% some other, lower-yield asset, a pro rata withdrawal will similarly contain that 60/40 ratio of both assets.
A sequential withdrawal, on the other hand, could come entirely from one or the other, or feature any combination of the two. Again, such flexibility greatly expands your saving potential, as the chart below illustrates (where Scenario #1 represents pro rata withdrawal, and Scenario #2 is sequential):
When it comes to employer-sponsored accounts like 401(k)s, pro rata withdrawals typically aren’t optional at all – they’re required. As you can probably guess, the reason for this is to prevent people from minimizing their tax liability in these accounts, which just goes to show how much of a difference sequential withdrawals can really make.
Sadly, there’s only so much you can keep away from the IRS. Sigh…
All snark aside, it’s important to know which of your savings, if any, are subject to the pro rata requirement. As for the rest, well… I know it looks like an intimidating amount of homework, but taking the trouble to map out a solid sequence of withdrawals is definitely worth the hassle. Take a second look at that graph just above to remind yourself. 😉
Putting the pieces on the board
There’s no guaranteed right answer to all the questions and considerations mapped out above. At the end of the day, every person’s situation is unique, which means that you have to make a choice and hope for the best.
BUT: as a financial planner, I’m here to remind you that you should never just make these choices without doing the math first – as best you can, anyway. You’d be surprised at just how much the math can predict. Hopefully the above pointers give you an idea of what to look for.
There is one last big topic to dig into, though. Once you’ve saved up for retirement, established what your income needs will be (and when!), and taken a good look at your tax liability, one big question remains – and this goes back to the whole “compounding” thing we started with. Namely: what returns can you expect from your savings, even as you’re using them up?
That’s a bigger can of worms than we can open here, but it’s definitely worth examining. So stay tuned for next week’s post, where we’ll pivot from sequence of withdrawals to look at sequence of returns.