How to Use the I.R.S. to Figure Out Safe Withdrawal Rates in Retirement
The Internal Revenue Service (I.R.S.) is not usually thought of as an institution that adds a lot of value to our lives — to the contrary in fact. However, a few years ago, the researchers at the Center for Retirement Research at Boston College came up with a simple and relatively safe retirement withdrawals strategy that is based on the Required Minimum Distribution (RMD) tables that the I.R.S. publishes each year.
While it certainly won’t erase the stress of your tax burden, maybe you can take some comfort from a safe retirement withdrawal strategy inspired by the I.R.S.
The Retirement Problem: How Much Can You Safely Withdraw Each Year in Retirement?
Figuring out how much money you can safely withdraw in retirement is tricky business. Get it wrong and you might find that you have scrimped and saved and have too much left over. Or, worse yet, you run out of money later in life.
There are various “rules of thumb” that can be applied to help you determine how much of your savings to spend each year to avoid calamity. However, the most widely used guide — the 4% rule — has been fairly widely discounted as a great strategy.
So, what are you supposed to do? Perhaps using the I.R.S.’s annual withdrawal percentage guidelines could be the answer you have been looking for.
A Retirement Income Solution: Get a Little Help from the I.R.S.
Some experts argue that perhaps the best rule of thumb for determining a safe retirement withdrawal rate is to actually use the I.R.S.’s Annual Percentage Withdrawal Table to determine optimal retirement withdrawals — for any account (and at any age).
You are probably aware that starting at age 72, you are required to withdraw a certain percentage of your 401k and IRA savings each year in order to avoid hefty tax penalties. The amount you must withdraw is published by the I.R.S. in the Required Minimum Distribution tables. The I.R.S. determines your withdrawal amounts by applying a formula that is based on life expectancy tables. The balance of your account is to be divided by your life expectancy factor (the average number of years someone your age is expected to live).
So, the RMD retirement withdrawal strategy is to apply the I.R.S. RMD formula to any account you want to tap for retirement expenses — at any age after retirement.
For example, if you are married and the younger spouse is 65, then the remaining life expectancy for at least one spouse is 32 years (it’s longer than a single life expectancy since you are projecting the life expectancy of either spouse). If you have account balances totaling $500,000, then the Boston College RMD strategy suggests that you could safely withdraw $15,500 this year. The $15,500 amount is determined by the following calculation: $500,000 divided by 32 — the number of years at least one of you are likely to continue to live — based on average life expectancy for either spouse.
As you age the percentage rises since you have a lower life expectancy, so at age 90 it’s about 9% of your total portfolio (for a married couple). If you had $500K remaining in your portfolio that would be about $45,000 in that year.
Why is the RMD Retirement Withdrawals Strategy a Good Idea?
A few of the reasons the Boston College researchers say that the RMD retirement withdrawals strategy is better than other rules:
It’s Simple: This strategy is easy to implement. It is not complicated math.
It’s Dynamic: This strategy reacts to changes in the financial markets. The system let’s you respond to changing market conditions.
Extra Income Later in Life: It allows you to withdraw more money each year as your life expectancy decreases — this is particularly beneficial if you are worried about healthcare costs as you age.
Better Outcomes: According to the Boston College researchers, the RMD strategy allows you more spending over your lifetime than the 4% rule and gives you a greater chance of having income from your savings for as long as you live.
What Are the Downsides of the RMD Retirement Withdrawals Strategy?
Nothing is perfect and there are two potential and significant downsides to the RMD retirement withdrawals strategy. Interestingly, some of the advantages of this method of calculating withdrawals are also downsides:
Lower Income When You Are Younger: The downside of having more income later in life is that you will be withdrawing less money when you are younger than when you are older.
While healthcare costs can be prohibitive at the end of your life, general retirement spending is usually higher when you first retire, then it gradually tapers as you age. So, depending on your spending, this may or may not be optimal withdrawal strategy.
- NOTE — How to Compensate for this Downside: There is a way to at least somewhat compensate for low income when you are younger. The Boston College researchers suggest one way to enhance the IRS withdrawals strategy. They suggest that you could boost your monthly retirement income by withdrawing all interest and dividends each year — in addition to the RMD amount.
Possibility for Income Variation: Depending on how well or poorly the stock market is doing, your income from withdrawals could potentially vary from year to year. While it can be a good thing to be flexible and keep pace with the markets, it can also give you a feeling of insecurity and make it harder to plan.
Your withdrawal rates respond to changes in the stock market since the amount you withdraw is based on your portfolio’s current value, contrary to other approaches that calculate withdrawals based on the value of your portfolio when you began drawing down your account.
Is a Withdrawals Strategy All That Important?
Knowing how much money you can safely withdraw each year in retirement is hugely important. Here are a few additional resources:
- 18 Strategies for Retirement Income
- Manage Withdrawals to Pay Less in Taxes
- The Spend Safely in Retirement Strategy
However, withdrawals are only one aspect of retirement planning and your strategy is more (or less) important depending on the reality of so many other personal finance details. Before withdrawing funds for retirement, you will want to create a completely comprehensive plan:
- Start by assessing what you have
- Figure out exactly what you need and would like to spend
- Look at the details that might sabotage your finances
- Create a retirement income plan tailored to meet the demands you yourself will face in the future
You probably have significant retirement income from Social Security. The trick is to calculate out how much more you might be spending every month and figuring out a reliable income plan for that difference.
A simple five question retirement calculator won’t do this for you, but there are some sophisticated tools available online.
The NewRetirement Retirement Planner is widely considered the best free online tool. It is highly detailed and easy to use, best of all it saves your information so you can quickly make adjustments as your finances and plans evolve.
And, once you have set up a baseline plan you can try any of the scenarios described above and assess whether or not it’s really a good idea for your future.