Planning for Retirement: Do You Have a Winning Hand?

Planning for retirement is in some ways like playing Bridge. You don’t know what cards or hands your opponents have, but you do know the strength of your hand based on statistics and experience.

Just like cards, there are plenty of retirement unknowns to deal with: You do not know what the future tax environment will be, what inflation or your return on investment will be, or what unforeseen costs you will face in retirement. But you do know your existing hand (existing resources and current spending needs).

Given this, are there ways to improve your chances of winning and achieving your life goals?

Start planning early!

Often we find that clients start thinking about retirement too late in life. For most people the question is, “Do I have enough resources to afford the lifestyle I envision at retirement?” The later in life people start planning and saving, the more their lifestyle could be impacted.

Understanding early in life the resources necessary to have the lifestyle you hope for makes it all the more likely you’ll be able to achieve your goals, given the time frame required to build those needed resources. And beyond building your resources, you have to plan ahead for where to hold them. That takes time, too. Just think about the difference between having all of your retirement assets in tax-deferred accounts (like 401(k)s and traditional IRAs) vs. in after-tax dollars. Planning is necessary to ensure that your retirement funds are not only sufficient, but also in the most tax-efficient buckets when withdrawals are needed.

A retirement ‘rule’ to take with a grain of salt

Everyone has heard of the “4% rule” when it comes determining if one will have sufficient assets to meet one’s retirement needs. This rule of thumb suggests that if you do not withdraw more than 4% a year from your retirement savings, your nest egg should last at least 30 years. Prior to the 1990s, most planners were using a 5% rule of thumb. However, a study using data going back as far as the ’30s showed that limiting oneself to a 4% withdrawal rate resulted in the 30-year statistical comfort zone.

This study was based on several factors, including a portfolio with average balanced risk. So, if your situation is different, the 4% rule may not be so cut and dried. For example, a higher-risk portfolio might need a lower withdrawal rate to compensate for the greater volatility. In addition, using a variable withdrawal amount vs. a fixed-dollar amount withdrawal rate can cause issues when it comes to cash-flow planning in retirement.

So, rather than relying solely on a static rule, it is best to develop a life plan or financial projection that is a living document, one that compares retirement resources against rates of return and living expenses and goals, is regularly updated and uses a statistically sound basis to determine the likelihood of having a successful retirement.

The bucket strategy

An equally important issue is the composition of one’s retirement portfolio. Too often we find all or most of retirees’ assets are in pretax accounts (qualified plans). That means when it comes time to make withdrawals to cover their living expenses, they’ll also need to pull an additional amount to cover the tax bill that comes with it. For example, going by the 4% rule, a retiree with an asset base of $3 million all in pretax accounts could withdraw a maximum of $120,000 a year. But if you assume an effective 25% tax rate, that would leave only $90,000 for living needs.

To maximize tax-planning flexibility, it is best to use a “bucket” strategy when planning for retirement. Think about filling a short-term bucket with roughly 20% of your retirement assets, or three to five years of retirement needs, that can be tapped without creating a significant taxable event. This bucket can hold cash or short-term fixed investments that can be readily used without triggering a big tax bill. This bucket can also contain Roth account assets, which can generally be tapped tax-free after age 59½. However, ideally Roth assets should be the last dollars used to fund living needs given their favorable tax treatment.

The second bucket would be filled with after-tax equity and longer-term fixed-income assets. This bucket could generate taxable events, given asset appreciation. But that burden is more manageable, given that the principal is all after-tax dollars.

The third bucket would be filled with all pretax assets, such as 401(k), traditional IRA and other pretax retirement accounts. These accounts are all subject to annual required minimum distribution (RMD) rules, starting at age 70½, and all distributions are taxed at ordinary income tax rates.

The ratio of assets in the second and third buckets is determined by whether you’ve saved enough to reach your lifestyle goal in retirement. If you have significantly more resources than you need to meet your retirement goals, the pretax assets could be higher. But, ideally, pretax assets should not make up more than 70% of retirement assets. That gives you more flexibility when tax planning.

Winning the retirement card game

The overall key is to start planning early and consider not only total assets but the inherent taxability of your retirement asset pool. In retirement planning, you can’t control some of the cards you’re dealt, but you can certainly control how they’re played.

This article is for informational purposes only. It is not intended as investment advice and does not address or account for individual investor circumstances. Please click here for important additional disclosures.