Funding Your Retirement

When many investors think about retirement, they focus on socking away cash and then investing it wisely to grow their nest egg. But there’s another critical—and often overlooked—piece of retirement planning: devising a strategy for withdrawing those carefully tended savings.

When it’s time to tap savings, some use the income their portfolio generates to support spending, or don’t have a plan to use all sources of return and to use their assets in a coordinated way to generate the cash flow desired.

That brings us to the final step of retirement planning—distribution. As with the planning and allocation steps, each person’s circumstances are unique. We all have different portfolios, and our needs and goals are our own. That said, some general principles apply to any retirement withdrawal strategy. It’s just a matter of drawing up a budget reflecting all of your income and spending expectations, and then devising a suitable distribution strategy. 

Paying for essentials with predictable income may help youavoid selling more volatile assets to cover your bills.

Aim to cover essentials with predictable income sources 

Social Security, pension payments, annuities, interest income, or even cash or short-term bonds kept in reserve are among the predictable sources of income you can use to cover essential expenses. Many retirees fall into the trap of tapping their more volatile investment assets to cover regular costs—such as housing, car loans, food and utilities—when they could be using income from more predictable sources supplemented by cash balances or a reserve of lower-volatility investments. Paying for essentials with predictable income may help you avoid selling more volatile assets to cover your bills, which can be particularly costly when the market is down.

Fund discretionary expenses with fluctuating income 

Stock dividends, distributions from mutual funds or exchange-traded funds, and proceeds from selling investments are less reliable than the predictable income sources cited above. This makes such income a good fit when paying for nonessential items, such as vacations or gifts to a charity or grandchild. Fluctuating income from dividends and other distributions also can help supplement Social Security payments and other sources of income outside your portfolio. 

Generate cash flow when you rebalance your portfolio

Selling investments as part of the annual rebalancing of your portfolio could provide another opportunity to generate cash flow. Annual portfolio rebalancing is especially important when you’re retired, as your allocation should generally become more conservative as you age, if you’ll need to tap those assets. A portfolio that’s out of balance can leave you with more risk or less growth potential than you want. These risks can be magnified in volatile markets because retirees have less time than younger investors to recover from the potential losses or lackluster returns caused by a portfolio that has strayed from a chosen asset allocation.

How do portfolios drift away from target allocations? During any period that certain asset classes rise or fall, it can leave many portfolios over or underweight areas of the market.

To help remedy an imbalance like this one, during periods when stocks rise in value, you could sell from the stock portion of your portfolio to generate needed cash and get your portfolio back on target. (See “Selling investments” below for more information.) Remember that rebalancing does not protect you against losses or guarantee that you’ll meet your goals. 

At the same time, you can use annual rebalancing to generate cash needed to support other income sources. In periods when stocks rise, rebalancing helps you tap gains to support spending. In down markets, you might tap investments that held their value or rose in value. The natural process of rebalancing, and the markets, helps you know what to tap when.

One mistake many retirees make is rely only on investment income, and not all of the source of returns, including a rise in the value of their investments, to support retirement spending. If you can live on investment income only, great. But don’t do so at the expense of growth potential in your portfolio, or forget that you have four sources you could tap: interest, dividends, capital gains and stable assets such as cash in your portfolio.

With these points in mind as you create your own distribution plan, watch for changes in your spending or income to ensure that your expectations are on track. In a prolonged down market, for example, you may want to curb or postpone discretionary spending to avoid drawing down your portfolio too quickly.

Creating income during retirement might sound daunting, but it doesn’t have to be. Three steps—planning, allocating and distributing—can help you simplify the process and lay the groundwork for the kind of retirement you’ve always wanted.

Selling investments

When it comes to selling assets, it may be better to tap investments in taxable accounts before taking money from tax-deferred or tax-free accounts, such as a traditional or Roth individual retirement account (IRA) or 401(k). That’s assuming you have enough savings and haven’t yet reached age 70½, the age when the IRS requires you to begin taking required minimum distributions (RMDs) from traditional IRA or 401(k) accounts. Withdrawals from traditional IRAs and 401(k)s are treated as ordinary income—which is typically taxed at a higher rate than long-term capital gains. What’s more, tapping your IRA earlier means losing potential opportunities for tax-deferred compound growth.

A possible exception is if your IRA balance is very large relative to other savings, or you need the money sooner. If that is the case, you might want to start taking distributions before you reach age 70½. Otherwise, when you start taking RMDs after age 70½, you might be bumped up to a higher tax bracket. Talk with your advisor or a tax professional to time your distributions wisely.

Next Steps

Explore additional steps for retirement planning in these related articles about planning for retirement and choosing the right mix of investments and distribution strategy to help you reach your goals.

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If you’d like to talk about your retirement plan, call a Schwab investment professional at 800-355-2162 or visit a branch near you.

Important Disclosures

Investing involves risks, including loss of principal.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, please consult with a qualified tax advisor, CPA, financial planner or investment manager.

Withdrawals are subject to ordinary income tax, and prior to age 59½ may be subject to a 10% federal tax penalty.

Diversification, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.