How to Turn a $1 Million Nest Egg Into a Lifetime Income Machine

There's nothing like a paycheck. Steady income pays the bills. Not to mention fun stuff like dinners out or a European getaway. But when you retire, the paychecks stop. The challenge, of course, is to turn your retirement nest egg into a steady paycheck that lasts a lifetime.

Let's say you’ve socked away $1 million. How do you turn that seven-figure account balance into a lifetime income machine that is able to fund the lifestyle you envision in retirement?

It starts with a game plan, says Nilay Gandhi, senior wealth adviser at Vanguard. "A lot of clients want to know whether what they have saved will be enough," says Gandhi. "But retirement security doesn't come in the form of a number. There needs to be a plan in place to help determine if they'll have sufficient funds."

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The starting line: know your number

Before building your income machine, you must figure out how much income you'll need after your working days are over.

If you've already done this exercise (as many Kiplinger readers have), jump to the next section on the "Five Ds."

Gandhi suggests a simple three-step audit.

First, add up your monthly must-pay expenses in retirement (housing, healthcare, car payments, etc.).

Next, account for "mad money" (travel, entertainment). Develop a realistic budget and spending plan that lets you withdraw what you need without outliving your money.

Finally, figure out where you will get the income to cover your expenses, such as Social Security, investments, rental income and the like. "You must layer all of those income pieces together and coordinate it so that you're able to turn those savings streams into a dream retirement," says Gandhi.

Once you know how much your portfolio needs to bridge, you can apply the "Five Ds" strategy.

The 'Five Ds' to turn your 401(k) into retirement income

When building a retirement income plan, there are five things that go into the decision and that you should think about, says Lindsay Theodore, a thought leadership senior manager at T. Rowe Price specializing in retirement and personal finance.

You want to make sure you have all the key bases covered so your income-generation plan holds up even in times of market stress.

Theodore refers to this income stream framework as the "Five Ds":

1. Diversification

The more diversified your income sources are, the better. "Social Security plays a big role," says Theodore. These government benefits are guaranteed, adjusted for inflation, and last for as long as you live. That's why waiting as long as possible to turn on Social Security and boosting your monthly benefit is a key plank in a retiree's income plan. Waiting until age 70 to take benefits provides 77% more monthly income than claiming at age 62, according to the Social Security Administration.

But relying on Social Security alone will result in a sizable income gap. "You need a mix of income sources," says Theodore. You can also generate income from, say, your target-date fund in your 401(k) that holds a mix of stocks and bonds. Or equity and fixed-income funds you own in a taxable brokerage account. Traditional pensions can also provide a steady income stream. Finally, an annuity that turns a lump-sum payment you make to an insurer into a guaranteed income stream also falls into this category. If you own rental properties, you can add that income stream to the pot, too.

2. Duration

You need your money to last, ideally through your entire lifespan. That's why income sources need to fill short-, medium-, and long-term buckets.

Your short-term bucket should be sitting in low-volatility assets that are not impacted by market swings and that you can access easily. Examples include high-yield savings accounts, money market accounts, short-term U.S. Treasury bonds, or CDs.

The medium bucket looks out three to 10 years and includes assets such as high-quality bonds and bond funds that can deliver some income while also dampening volatility.

Your long-term bucket, or growth bucket, should consist of well-diversified stock funds and exchange-traded funds (ETFs) that deliver long-term growth and inflation protection.

3. Downside protection

If you want to generate consistent income without prematurely draining your account balance, make sure you don't invest all the assets you can pull from in stocks or other assets that can drop sharply. You want plenty of money in a so-called rainy-day type of fund that holds its value in down markets and can be withdrawn easily. Having this cash handy means you won't have to sell assets in a declining market to pay the bills.

"You need guaranteed income from conservative assets," says Theodore. "We recommend retirees have 13 months to 24 months of cash (or cash-like equivalents) on hand."

Having that much cash available will help retirees ride out most stock bear markets without tapping their stock holdings when prices are depressed. That unfortunate effect is known as the sequence of returns risk.

Going back to 1929, the 12 "garden-variety" bear markets, or downdrafts between 20% and 39.99%, have averaged total declines of 27.6% for the S&P 500 stock market, according to S&P Capital IQ. The good news? The market recovered all its losses in 13 months, on average.

4. Discretion

The ability to access assets at a moment's notice to pay for an unplanned expense or other financial emergency is also key to a sound retirement income plan. Discretion refers to how liquid a retirement account balance really is. Retirees need to easily access their savings when they need to.

"Having withdrawal flexibility is important," says Theodore. "With these types of withdrawals in mind, it could help you determine how much you want to allocate to each of your sources of income in retirement." For example, you don't want 100% of your assets in stocks, which are volatile and can drop sharply from time to time.

5. Drag

You want to avoid so-called tax drag and high fees that eat into your account balance. "You especially want to minimize taxes," says Theodore. That's why you should be mindful of the tax impact of any withdrawals you make in retirement.

For example, a withdrawal from a traditional 401(k) funded with pre-tax dollars will be taxed at your ordinary tax rate. In contrast, withdrawals from a Roth IRA or Roth 401(k) are tax-free, since you contributed after tax. The less you pay in taxes, the more money that stays in your accounts. "(Smart) withdrawals can help your money last longer," says Theodore.

This is where tactical withdrawals come in. For example, you might consider drawing down your tax-deferred retirement accounts and delaying Social Security. The benefit is two-fold. First, by drawing down your 401(k) assets, which are taxed as ordinary income, you will reduce the amount of required minimum distributions (RMDs) you will have to take at 73 (or 75, depending on your birth year). That will in turn reduce the amount of income you’ll have to pay taxes on. The second benefit is that you can potentially wait until age 70 to start taking Social Security benefits, which will ensure you receive a much higher monthly benefit than if you turn on benefits at age 62 or even at full retirement age.

How much should you withdraw from your nest egg in retirement?

A common rule of thumb is to withdraw 4% of your retirement savings each year to supplement guaranteed income streams and ensure your money lasts at least 30 years. So, if your retirement account balance is $1 million, a 4% withdrawal rate will net $40,000 in annual income.

Here's an example of how you can create a paycheck from $1 million in savings.

Let's say you need $80,000 in annual income and expect to receive $40,000 in guaranteed Social Security income. That leaves you with a $40,000 savings gap.

You'll cover the rest from your own savings. Here's how it might work.

Let's say you follow personal finance experts' advice and build a variety of income streams to draw from. You have 60%, or $600,000, of your $1 million nest egg invested in a target-date retirement fund; 10%, or $100,000, in an annuity earning 6.5%; 10% in a core bond fund yielding 5%; 10% in a money market paying 3.5% interest; and 10% in growth investments from which you can withdraw 4% annually.

This diversified approach of pulling income from different buckets will generate $43,000 in income, or $3,000 more than you need. That extra $3,000 could fund a fun vacation but also serve as a cushion against inflation or a health care emergency.

The key is to make use of all the income streams you have and to coordinate withdrawals from the buckets to make your money last as long as possible, says Vanguard's Gandhi.

What's the biggest mistake retirees make that puts their revenue stream at risk over time?

"(They lack) withdrawal discipline," says Gandhi. In other words, they spend too much, which forces them to take much larger distributions than their plan calls for.

"You need to stick to spending rules," says Gandhi. "Money can be emotional. But you can't let your emotions rule."

Read More

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• 6 New Ideas to Generate More Retirement Income
• 5 Ways To Increase Your Investment Income In Retirement
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• How to Turn Your 401(k) Into A Real Estate Empire — Without Killing Your Retirement