You'd think that when you reach retirement, the most logical step in the world would be to begin drawing on your retirement account.
Not so fast. Planning your income stream in retirement is a complicated endeavor. Moreover, it's a brand-new skill. You spent your working life accumulating assets. Now it's time to draw them down in a sensible way that ensures they last until you die, maximizes your Social Security, minimizes your taxes and, if possible and if you so desire, transfers a remainder to your heirs.
"Most people are not able to easily convert stock to flow," said Charles D. Ellis, an investment management expert and author of the classic "Winning the Loser's Game." He added, "We are just not in practice at it."
He told the story of a friend who occasionally calls for investment advice on how to make her assets last. Though she assured him she was only spending a little bit, he kept asking for specifics.
"I asked, several times, how much are you actually spending?" he remembered. "Finally, she said, 'just 10 percent.'"
Ten percent, of course, is probably way too much. Given that your life expectancy at 65 is another 20 years for men and 22 for women, spending 10 percent a year will likely result in running out of money.
The rule of thumb is 4 percent—though some advisors argue it could be as high as 5 percent to 6 percent a year for many people. The amount is a function of how easy it is to make money from your assets, to replace what you are taking out and losing to inflation.
In retirement, you can probably draw more in a high interest-rate environment, where you can find relatively secure income-generating investments, like some corporate or government bonds.
"The long-term capital draw from a properly allocated portfolio is 4 percent to 6 percent," said David Edwards, president of New York City-based Heron Financial Group. "We're going to use a 5 percent draw rate until interest rates go up."
After you determine how much you can draw and still have enough to last for your lifetime, the question is how to draw from your accounts in a way that maximizes your Social Security payments and minimizes your taxes.
Many people get focused on the latter in retirement. Avoiding taxes is important, but remember to balance that need against your desire to enjoy your retired life.
Experts caution that every individual's case is different—for instance, all of your decisions could be radically different if you or your spouse has a glum health prognosis, a disabled child or an all-consuming yen to travel around the world. "There's no real equation for doing it," said Brian Parker, managing director and co-founder of Los Angeles-based EP Wealth Advisors.
Here are five guidelines for tapping your accounts.
1. Delay claiming Social Security for as long as you can. If you delay claiming Social Security from 62—the earliest age at which you can claim—until 70, you will increase your maximum monthly benefit by 76 percent, said Ellis, who is co-author, along with Alicia Munnell of Boston College's Center for Retirement Research, of the upcoming "Falling Short," a book due out in November about the retirement crisis.
You could do this by choosing to work or working part-time.
But if you retire, you'll have to begin drawing on your retirement accounts or other assets to pay for your living expenses.
It may be tempting to claim Social Security earlier and leave your portfolio untapped. Don't, said Edwards.
"Pull your own Social Security statement, add up all the money you paid over the years, and look at your projected benefit. This is a great investment," he said. "Do what you can to draw Social Security at 70 to maximize that cash flow. You cannot underestimate the value of having that guaranteed income stream."
2. Take your money from taxable accounts first. It is to your advantage to extend the tax-free compounding that happens in your retirement accounts for as long as you can. So if you've arrived at retirement lucky enough to have assets outside your retirement plans, take those down to zero, though remembering that at whatever age you are, you need to have a liquid cash reserve of three to six months of income for emergencies.
The gains on the investments held in your taxable accounts will be taxed at the long-term capital gains tax rate, which differs depending on your income level. For almost everyone, the tax on net capital gains is 15 percent, according to the IRS. If you are making more than $400,000 a year, it might be higher.
You might also draw on Roth IRS during this period, Edwards said. Because you paid taxes on the money in your Roth IRAs before you invested in them, you won't be taxed on the distributions.
3. At 70.5, begin taking your required minimum distributions. By law, you must start drawing on your retirement accounts, at minimum amounts dictated by the IRS. The minimum amounts are set by a calculation: The account balance at the end of the preceding calendar year divided by the distribution period from the IRS's "Uniform Lifetime Table."
For example, the minimum distribution on a $500,000 IRA at age 70 would be a little more than $18,000. Here's more information about distributions. Remember, all of your distributions from those tax-free accounts will be taxed at your income-tax level.
4. Leave your Roths until the end. If the minimum distributions meet your income needs and you still have some money left in Roths, it's in your interest to leave it there—or rather, your heirs' interest, said Parker. You can leave any IRA to the next generation; if you do, it becomes an inherited IRA and falls under the tax and distribution rules for that kind of account. If the IRA was a Roth IRA, your children or other heirs won't have to pay income taxes on the withdrawals.
5. Consider your marriage status. If you are married, it's probably to your tax and psychological advantage to negotiate your draw-down strategy together and draw from plans in both of your names. Edwards said that he had one "old-school" client who wanted to draw down all of his assets before touching any of those in his wife's name, without regard to the tax implications—probably a mistake.
But don't forget to consider the increasingly likely possibility of divorce in your grayer years. If you draw down one spouse's assets first, it might make splitting up your retirement accounts more difficult in the case of a split.
Retirement requires a change in mind-set about your money, as you go from accumulating assets to preserving them. Your mind-set about your marriage may change, too.