When you retire, you need to start withdrawing money from your 401(k) or other investment accounts. This requires a huge mindset shift as you have been building these accounts your entire life. And you have to be smart about when and how much you withdraw.
Before you start considering distributions, it’s important to do one important thing first.
Complete this step before withdrawing money from your retirement account
Before you withdraw your retirement assets, you must set a secure withdrawal rate. This is basically an amount of money that you can take out of your investment accounts without take a huge risk of draining your account too soon.
You see, you have to rely on your retirement savings throughout your retirement years. They cannot live on Social Security benefits alone without additional savings. This is not possible because Social Security only replaces 40% of pre-retirement income and you need to replace around 70% to 80% of what you earned before you retired. Social Security benefits also lose value over time, so you’ll need your savings even more later in life. This happens because the benefit increases built into Social Security don’t work very well to offset the inflation that seniors are experiencing.
If you withdraw too much money from your retirement accounts too quickly, you won’t be left with enough money invested in income-generating assets. Your returns will start to fall, causing your account balance to shrink even more with each payout. Eventually you could end up with $0.
Setting a safe payout rate helps reduce the likelihood of this happening. You still have plenty of money working for you and earning returns if you limit the number of withdrawals at once. For example, if you can earn 7% per year in returns and only withdraw 4% or 5% of your account balance, then the overall value of your account will not decrease even if you withdraw funds.
How can you set a safe payout rate?
In an ideal world, you could live off only the interest you earn and avoid reducing your capital balance. But that often doesn’t work in practice.
Seniors typically need to invest conservatively because they can’t afford to risk big losses when the market falls. They may not be able to wait for a recovery if they are over-invested in stocks. And even if you make generous returns a few years from now, there may be years when you don’t and you still have to rely on your savings for income.
This means you need a different withdrawal strategy.
A common rule that seniors follow is to withdraw 4% from their retirement accounts in the first year of retirement, and then increase their withdrawals each year to match inflation. While the probability of running out of money using this approach used to be fairly low, lower projected future returns and longer life expectancies have made adhering to the so-called 4% rule more dangerous.
The Center for Retirement Research recommends an alternative approach: Use the IRS-produced Minimum Distribution (RMD) tables for calculating 401(k) withdrawals to determine how much you need to withdraw from all of your accounts — even if you there are not yet required to take RMDs.
You can also work with a financial advisor to develop a personalized approach that’s right for you given your age, risk tolerance, lifespan and the amount you have invested to support yourself. Whatever you do, don’t withdraw any money until you’ve decided how much you can comfortably afford to withdraw, or you might end up really regretting it.
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