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In retirement, it’s finally time to withdraw money from the savings accounts you’ve (hopefully) been investing in throughout your working years.
But while how much to withdraw is an important decision, so is the way you make these types of withdrawals. The decision will impact your taxes, long-term wealth and other facets of your finances. Here’s what you should consider to make the most of your money.
What is sequence of return risk?
Sequence of return risk refers to the danger that withdrawals during times of poor market performance early in your retirement can hurt your overall returns for years to come.
An example from Charles Schwab shows that two investors who retire with $1 million could end up with very different portfolios after 18 years: one who experienced a 15% decline during the first two years of retirement could see their portfolio depleted while the other, who experienced a 15% decline during the 10th and 11th years of retirement, would still have $400,000.
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How to minimize your risk
Strategically drawing down your retirement accounts can help you minimize sequence of returns risk.
Retirees can benefit by having a strong cash reserve that will cover at least one to two years’ worth of their expenses so that they aren’t forced to sell during a market downturn to cover their needs. If retirees do have to sell, they can benefit from reducing their withdrawals when the stock market isn’t performing well. For instance, if you typically withdraw 4% from your portfolio annually, you may want to scale back to 1% or 2%, during a period of poor market performance, if possible.
You can also sell winning investments in your portfolio first so that you’re not selling at a loss.
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Strategic withdrawals
It’s also important to consider which accounts you’re withdrawing from, and in which order. The right method for you will come down to your specific tax situation, but here is a general guide that may work.
A traditional approach is to start with withdrawing from your taxable brokerage account. You’ll have to pay capital gains taxes if you turn a profit.
Next up are tax-deferred accounts. These withdrawals are treated as ordinary income, and you can gradually withdraw from them each year to minimize the impact of required minimum distributions (RMDs), which take place when you turn age 73.
Finally, you can pull tax-free from your Roth retirement plans.
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The benefit of strategic withdrawals
Strategically withdrawing across multiple accounts can minimize your tax burden. Smart tax and withdrawal planning can also mean you get to keep more of your Social Security checks by lowering the amount of tax you owe on the benefits.
Minimizing your tax burden is especially important during your early years of retirement. Paying lower taxes during the start of your golden years gives your money more time to compound. Even an extra one or two years of compounding may lead to more financial flexibility and less money stress.
