One of the most common questions clients ask when doing their retirement planning is how portfolio withdrawals will work. Saving is something most clients have done for years, but reversing the flow brings up a host of questions. Financial advisors, in our typical attempt at using plain language and avoiding jargon, refer to this as decumulation and a decumulation strategy is core part of retirement planning.
Where – that is from which accounts – to withdraw and in what sequence is usually driven primarily by tax considerations. Different types of accounts are taxed differently, and tax treatment ranges from treating every dollar withdrawn as taxable income to no tax impacts whatsoever for amounts withdrawn or income generated within the account. A well-crafted decumulation retirement planning strategy can help keep taxable income at targeted levels, and that can be beneficial during retirement in several ways.
The most obvious benefit of targeting taxable income is that it keeps taxes predictable, and – for most clients1 – minimizes income tax paid during retirement. Beyond that, the percentage of your Social Security income that is counted as income as well as Medicare premiums are both impacted by taxable income. Lastly, many counties and municipalities offer income-based homestead exemptions for homeowners age 65 or older. In some instances, the exemptions are permanent once granted so it can be advantageous to keep income lower than usual for a given year to qualify for the exemption.
Once we’ve worked with clients to determine what accounts to use to cover needs, the next step is to determine how withdrawals happen. Most clients like to receive monthly transfers as it feels identical to the direct deposit they received while they worked. A lump sum transfer – annually, for example, is also an option as is simply writing checks from taxable brokerage accounts. For IRAs, another issue to consider is whether and to what extent to withhold a portion of the withdrawal for Federal and State taxes. As is the case with the method of withdrawal, whether or not to withhold is a matter of personal preference, but clients definitely want to avoid under-withholding across all income and being subject to an underpayment tax.
One final issue clients raise when it comes to drawing on their portfolios is how to replenish the cash they withdraw. In most cases, this is done via rebalancing. Rebalancing is the process of buying and selling investments to move the portfolio back to the target allocation. In years when the market is up, cash is typically generated by selling stock funds that have increased in value, while in down years, the cash may be generated by selling bond funds. In either case, securities are sold in the accounts the client has chosen to draw from, and cash is replenished to cover ongoing needs in retirement.
- Some clients elect to pay more in taxes during retirement so that their kids will pay less in taxes on the assets they inherit. ↩