Planning a tax-efficient retirement withdrawal plan is vital to ensure your savings last as long as possible. As Ray Lucia Sr. notes, factors like market volatility, tax treatment of different accounts, and the sequence of returns all play a role in shaping the optimal approach. Using bonds before stocks, managing the risk from early market downturns, and understanding how to locate assets within taxable and tax-advantaged accounts can collectively improve your outcomes.
Optimizing the Order of Retirement Withdrawals
Spending bonds before retirement stocks refers to drawing income from the bond portion of a portfolio while allowing the equity portion to remain invested. This challenges the common habit of withdrawing evenly or proportionally from all assets without considering the potential long-term impact.
The order in which retirees withdraw funds can affect how long their savings last. Traditional strategies like the 4% rule assume a fixed withdrawal rate, but they don't always account for market conditions or asset behavior.
A retiree who begins drawing from equities during a market downturn might lock in losses, reducing the portfolio's ability to recover. By contrast, using bonds first—especially during volatile periods—can give equities more time to rebound and potentially extend the portfolio's overall lifespan.
How Bonds and Stocks Behave
Stocks and bonds serve different roles in a retirement portfolio. Stocks have historically offered higher long-term returns but come with greater short-term volatility. Bonds, on the other hand, tend to be more stable and can act as a cushion during market turbulence.
During retirement, the sequence and timing of returns become crucial. If the market takes a downturn just as someone begins withdrawals, having a portion of the portfolio in bonds can help provide income without needing to sell stocks at a loss.
Market performance doesn't follow a predictable pattern year to year, and this unpredictability makes the presence of lower-volatility assets like bonds valuable. While they may not yield the same growth as equities, their steadier returns can help smooth out the ride, especially when regular withdrawals are needed.
Managing Sequence of Returns Risk
Sequence of returns risk refers to the danger of experiencing negative investment returns early in retirement, which can have an outsized impact on long-term portfolio health. This risk is less about the average return over time and more about when losses occur. The earlier the losses, the more devastating the impact on savings.
A retiree who faces a bear market in the first few years while withdrawing from stocks may run out of money faster than one who encounters the same returns later. By tapping into bonds during those early years, retirees can avoid selling stocks at depressed prices, giving their equity holdings a chance to recover.
Conserving equities during turbulent times isn't just about avoiding losses—it's about preserving future growth. Choosing to spend from bonds first can act like a buffer that softens the impact of early down years, which is often when portfolios are most vulnerable. The strategy can be particularly beneficial during recessions or unexpected economic shocks.
Tax Efficiency and Asset Location
Not all retirement accounts are taxed the same way, and the type of account from which you withdraw can significantly shape your tax bill. Taxable accounts, traditional IRAs, and Roth IRAs each have different rules, and knowing how to sequence withdrawals from them can help minimize taxes over time.
Holding bonds in tax-advantaged accounts, such as traditional IRAs, may be beneficial because the interest they generate is typically taxed as ordinary income. By keeping more tax-efficient assets like stocks in taxable accounts, retirees may be able to take advantage of lower long-term capital gains rates. This kind of strategic placement, often known as asset location, can lead to better after-tax returns.
Tax-smart withdrawal planning also involves considering required minimum distributions and how Social Security benefits are taxed. Coordinating withdrawals with these rules can reduce the chance of being bumped into a higher tax bracket, allowing retirees to keep more of what they've saved. A well-structured withdrawal sequence can also extend the life of Roth accounts, preserving tax-free growth for later years or heirs.
Choosing and Applying the Right Approach
Personal factors like spending needs, life expectancy, and comfort with market swings all influence the best withdrawal plan. There's no one-size-fits-all answer, and a method that works well for one household might not suit another.
Spending stocks first could make sense in unique situations, such as when equities have outperformed, and rebalancing is needed. In other cases, retirees might benefit from setting aside a few years of expenses in cash or short-term bonds to weather market dips without disrupting their long-term investment plan.
Disclaimer: Ray Sr. is a consultant and trainer and is not currently registered as a financial advisor. The content produced from these topics is intended for educational and informational purposes only and should not be construed as legal, tax, investment, or financial advice. Readers should consult with qualified professionals regarding their specific situations.
