Oct 29, 2024 | 8 min read
While retirement may feel like a far-off dream for young professionals, here's an insider tip: mastering the art of withdrawing from your retirement accounts is just as crucial as learning how to save and invest. In fact, according to Vanguard's Advisor's Alpha research, a smart withdrawal strategy can add up to 0.70% to your annual returns. This might not sound like much, but over time, it can significantly impact your wealth and the longevity of your retirement savings. Let's dive into why this matters and how it works.
The Power of Retirement Withdrawal Order
When you reach retirement, you'll likely have multiple investment accounts to draw from: taxable accounts (like regular brokerage accounts), tax-deferred accounts (like traditional 401(k)s and IRAs), and tax-free accounts (like Roth 401(k)s and Roth IRAs). The order in which you withdraw from these accounts can significantly impact how long your money lasts.
Let's look at some data to see why this matters:
Average internal rate of return of different retirement withdrawal order strategies
Notes: These hypothetical data do not represent the returns on any particular investment. Each IRR is calculated by running the same 10,000 VCMM and simulations through three separate models, each designed to replicate the stated withdrawal-order strategy (see Appendix for description and disclosures). Source: Vanguard
This chart shows the average internal rate of return for different withdrawal-order strategies. The results are striking:
Spending taxable assets prior to tax-advantaged: 1.70% return
Spending tax-deferred assets prior to taxable: 0.50% return
Spending tax-free assets prior to taxable: 0.50% return
The strategy of spending taxable assets first leads to a significantly higher return - more than three times higher than the other strategies! Understanding the Assumptions
Before we dive deeper, it's important to understand the assumptions behind this analysis:
Source: Vanguard
These assumptions provide context for the results. They represent a balanced portfolio with a long time horizon and relatively high tax rates. Your specific situation might differ, but the principles remain the same.
The Optimal Withdrawal Strategy
Based on this data and further research, financial experts have developed a recommended withdrawal order. Here's a detailed look at how it works:
Source: Vanguard
Start with Required Minimum Distributions (RMDs) If you're 72 or older (70½ if you reached 70½ before January 1, 2020), you're required to take minimum distributions from most retirement accounts. Always start here to avoid penalties.
Use Taxable Account Flows Next, use any dividends, interest, or capital gains distributions from your taxable accounts. You'll pay taxes on these anyway, so you might as well use them for spending.
Sell Assets in Taxable Accounts If you need more money, start selling assets in your taxable accounts. This allows your tax-advantaged accounts to continue growing tax-free or tax-deferred.
Choose Between Tax-Deferred and Tax-Free Accounts The choice between these depends on your expected future tax rates:
A. If you expect to be in a higher tax bracket in the future:
1. Use tax-deferred accounts next
2. Then use tax-free accounts
B. If you expect to be in a lower tax bracket in the future:
1. Use tax-free accounts next
2. Then use tax-deferred accounts
Key Reasons This Strategy Works
Tax Efficiency By using taxable accounts first, you allow your tax-advantaged accounts to grow for longer, maximizing the benefits of tax-deferred or tax-free growth.
Flexibility This strategy gives you flexibility to adjust based on tax law changes or changes in your personal situation.
Legacy Planning If you have assets you plan to leave to heirs, leaving tax-advantaged accounts untouched for longer can be beneficial for estate planning purposes.
RMD Management By depleting tax-deferred accounts strategically, you can potentially reduce your RMDs in the future, giving you more control over your taxable income in retirement.
The Impact of Smart Withdrawal Strategies
To illustrate the power of this strategy, let's consider a hypothetical example:
Imagine two retirees, Alex and Sam, both age 65 with $1 million in retirement savings split evenly between taxable, tax-deferred, and tax-free accounts. They both need $50,000 per year from their portfolio.
Alex follows the optimal withdrawal strategy outlined above. Sam withdraws proportionally from all accounts.
After 20 years:
Alex has about $1.2 million left
Sam has about $950,000 left
That's a difference of $250,000 - just from withdrawing in a different order! This example is simplified, but it demonstrates how powerful a smart withdrawal strategy can be over time.
Common Pitfalls to Avoid
While the optimal strategy seems straightforward, there are several pitfalls that retirees often fall into:
Withdrawing from tax-deferred accounts too early This can push you into a higher tax bracket and reduce the benefit of tax-deferred growth.
Neglecting to consider future RMDs If you don't plan for RMDs, you might be forced to take larger taxable distributions than you want in the future.
Ignoring state taxes Some states tax retirement account withdrawals differently. This can impact your optimal withdrawal strategy.
Failing to adjust for market conditions In a down market, it might make sense to temporarily adjust your withdrawal strategy to avoid selling depreciated assets.
Not considering the impact on Social Security benefits Your withdrawal strategy can affect the taxation of your Social Security benefits.
Implementing the Strategy: Tips for Young Professionals
While retirement might seem far off, there are steps you can take now to set yourself up for success:
Diversify Your Account Types Don't put all your eggs in one basket. Contribute to a mix of taxable, tax-deferred, and tax-free accounts.
Understand Your Accounts Know the tax implications of each type of account you have.
Plan for RMDs Remember that traditional IRAs and 401(k)s will require distributions starting at age 72. Roth accounts don't have RMDs for the original owner.
Consider Roth Conversions If you're in a low tax bracket now, consider converting some traditional IRA money to a Roth IRA. You'll pay taxes now, but it could save you money in the long run.
Stay Informed Tax laws change. Stay informed about how these changes might affect your withdrawal strategy.
Use Tax-Efficient Investments in Taxable Accounts In your taxable accounts, consider using tax-efficient investments like index funds or ETFs. This can reduce the tax impact when you start withdrawing from these accounts in retirement.
Think About Your Career Trajectory Your current and future income levels can impact your optimal saving and withdrawal strategies. If you expect your income (and tax rate) to increase significantly, you might prioritize Roth contributions now.
Start Thinking About Retirement Lifestyle Your withdrawal strategy will be influenced by your retirement spending needs. Start thinking about what kind of lifestyle you want in retirement and how much it might cost.
The Role of a Financial Advisor
While this strategy seems straightforward, implementing it effectively can be complex. A financial advisor can help by:
Personalizing the Strategy Your optimal withdrawal order might differ based on your specific circumstances, including your tax situation, other income sources, and estate planning goals.
Managing Taxes An advisor can help you manage your tax bracket from year to year, potentially saving you significant money over time. This might involve strategies like Roth conversions in low-income years or harvesting capital losses in taxable accounts.
Adjusting for Life Changes As your life circumstances change - perhaps you inherit money, change careers, or have health issues - your advisor can help adjust your strategy accordingly.
Navigating Complexities Issues like Social Security claiming strategies, healthcare costs, and legacy planning can all impact your withdrawal strategy. An advisor can help you navigate these complexities.
Providing Behavioral Coaching Just as with investing, emotions can sometimes lead to poor decisions in withdrawals. An advisor can help you stick to your plan even when markets are volatile or your circumstances change. Learn more about benefits of behavioral coaching in our recent article.
Optimizing Asset Location Your withdrawal strategy is closely tied to how your assets are located across different account types. An advisor can help ensure your assets are optimally located for both growth and eventual withdrawal. Learn more about asset location techniques here.
Keeping You Updated Tax laws and retirement account rules change frequently. A good advisor will keep you informed about changes that could impact your strategy.
Final Thoughts
The order in which you withdraw from your retirement accounts might seem like a small detail, but as we've seen, it can have a big impact on your wealth over time. By following a smart withdrawal strategy, you could potentially add 0.70% to your annual returns - a significant boost that compounds over time.
As a young professional, you have a powerful advantage: time. By understanding these concepts now and setting up your accounts accordingly, you're positioning yourself for a more secure and flexible retirement. You're not just saving for retirement; you're setting up a strategic plan for how to use those savings most effectively.
Remember, while the principles of smart withdrawals are straightforward, implementing them effectively over decades can be complex. It involves ongoing decision-making, adapting to changing tax laws and personal circumstances, and balancing competing financial goals. Don't hesitate to seek professional advice to ensure you're making the most of your hard-earned savings.
The key is to start thinking about these issues now, even if retirement seems far off. By doing so, you're not just planning for retirement - you're planning for a lifetime of financial well-being.
For a more comprehensive look at how financial advisors can add value through withdrawal strategies and other techniques, check out our in-depth blog post: The Hidden Value of Financial Advisors: More Than Just Investment Returns.
At Israilov Financial, we specialize in developing personalized withdrawal strategies to help maximize your retirement savings and minimize tax impact. If you're interested in learning how we can optimize your retirement spending plan, schedule your free discovery meeting.
Appendix:
About the Vanguard Capital Markets Model
The Vanguard Capital Markets Model® (VCMM) is a proprietary financial simulation tool developed and maintained by Vanguard’s Investment Strategy Group. Part of the tool is a dynamic module that employs vector autoregressive methods to simulate forward-looking return distributions on a wide array of broad asset classes, including stocks, taxable bonds, and cash.
Limitations: The projections are based on a statistical analysis of December 31, 2021, yield curves in the context of relationships observed in historical data for both yields and index returns, among other factors. Future returns may behave differently from the historical patterns captured in the distribution of returns generated by the VCMM. It is important to note that the model may be underestimating extreme scenarios that were unobserved in the historical data on which the model is based.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
IMPORTANT DISCLAIMERS
Past performance is no guarantee of future returns
The graphs and charts in this commentary are for illustrative purposes only and not indicative of any actual investment. Index returns do not reflect any fees, expenses, or sales charges. It is not possible to invest directly in an index. Stocks are not guaranteed and have been more volatile than other asset classes. Historical returns were the result of certain market factors and events which may not be repeated in the future. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgement in determining whether investments are appropriate for clients.
This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities.
Disclaimer: Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Israilov Financial LLC cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Israilov Financial LLC does not provide tax or legal advice, and nothing contained in these materials should be taken as such.
As always, please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Israilov Financial LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Israilov Financial LLC unless a client service agreement is in place.
Comments