Lynn Brenner's Family Finance

How to Turn a Retirement Portfolio Into Income (Part 2)

 

Q: What's a good way to withdraw annual retirement income from an investment portfolio? --DA, via email

 

A: I like the two-bucket method. It has the virtue of simplicity, and it makes sense both emotionally and fiancially.

But the caveat I cited in my last post applies here, too: It won't work well if you don't have enough money.

Here's the idea:

When you retire, you divide your nest egg into a Cash Flow Bucket and an Investment Bucket.

Fill the Cash Flow Bucket with enough money to cover your living expenses for two years. Keep it in a money market fund.

Fill the Investment Bucket with a mix of stock and bond funds. The most appropriate mix depends on factors like the size of your portfolio, your other sources of income, your life expectancy, your assumptions about future market returns and inflation rates, and your appetite for risk. My own best guess is that a healthy 65 year-old shouldn’t have a stock/bond mix more aggressive than 65/35 or more conservative than 50/50.

Clear so far?

Okay, let's look at an example.

Let's give you a $1 million nest egg, and say you want to withdraw a constant $45,000 a year (i.e., $45,000 after inflation) to cover your living expenses. In other words, your annual spending rate will be 4.5% plus inflation. In effect, you've turned your portfolio into an inflation-adjusted annuity. These $45,000 withdrawals will supplement your monthly Social Security benefit and any other income you may have, such as a pension or earnings from a part-time job.

You'll put $90,000 into your Cash Flow Bucket. Every month, you'll write yourself a money market fund check for about $3,800.

Think of this as your paycheck.

The remaining $910,000 goes into the Investment Bucket's mix of stock and bond funds. Once or a year you'll rebalance this portfolio back to your original allocation. When you rebalance, you'll also transfer enough money out of Investment Bucket into the Cash Flow Bucket to bring its balance back up to $90,000.

What if you don't need to rebalance the Investment Bucket that often because your allocation hasn't changed?

In that case, when there's less than a year’s worth of expenses remaining in the Cash Flow Bucket, you'll examine the contents of the Investment Bucket to identify what to sell to replenish your Cash Bucket. Remember, you want to sell shares of funds that are doing well. You should avoid selling an investment that is experiencing significant losses; you want to give it the time to recover.

Sell enough of an investment that is doing well to provide the money to bring the Cash Flow Bucket balance back to $90,000. Don't forget to rebalance the Investment Bucket after you've done this.

Okay -- but what if nothing is doing well in the Investment Bucket? What if all your investments are losing value? A bear market in both stocks and bonds lasting longer than a year is unlikely, but not impossible. In that case, you replenish your Cash Flow Bucket by liquidating some of your most conservative bond holdings, says Harold Evensky, the fee-only financial adviser who pioneered the two-bucket method. He recommends that your Investment Bucket contain about three years worth of living expenses in short-term, high quality bonds.

In other words, this approach gives you liquidity enough to cover up to five years' worth of withdrawals: two years in the Cash Flow Bucket, plus three years in the Investment Bucket.

The beauty of this system is that it’s relatively simple. It's comfortingly familiar because it preserves the psychological distinction between your checking account and your investment portfolio. It offers some protection against having to sell stocks at the worst possible moment. And it helps provide emotional stability: you're less likely to agonize over market volatility if you know you have enough cash on hand to cover a couple of years’ worth of living expenses.

But it’s no coincidence that financial planners and columnists so often use a $1 million portfolio to illustrate such strategies: You need that big a nest egg if you want to withdraw $45,000 a year, adjusted for inflation, for up to three decades of retirement. In fact, if your annual, inflation-adjusted withdrawals exceed 5% of your initial portfolio, you run a serious risk of outliving your savings.

In my next post, I’ll explain why that is.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

 

How To Tap A Nest Egg For Annual Income In Retirement

Q: Do you have any advice on how to withdraw retirement income from a portfolio that combines a total bond fund, a total stock market fund, and a money market fund? – DA via email

 

A: There are no easy answers to this question unless you have so much money that you don't need to ask it. But there are sensible ways to approach the problem, which I'll discuss in the next several posts.

Let’s address it as three related questions: What’s the best way to invest your portfolio in retirement? What’s a practical method for taking annual withdrawals? And how much can you withdraw every year without running out of money?

You’re definitely on the right track with a portfolio that combines stocks, bonds, and cash; and I applaud what sounds like a decision to use index mutual funds. It's smart to invest as simply and as inexpensively as you can; and there's nothing simpler or less costly than index funds.

But I think you need more than three funds. In a very basic retirement portfolio, I'd consider owning three bond funds (one very short-term fund, one intermediate-term fund, and one Treasury Inflation-Protected bond fund), and at least two stock funds (one for U.S. stocks and one for international stocks.)

The ideal retirement portfolio, which I described in a recent article for AARP Bulletin, contains about five years’ worth of living expenses in cash and very short-term bonds, with the balance divided between stocks and longer term bonds.

"Five years is roughly the length of an economic cycle," explains Harold Evensky, a Coral Gables Florida financial planner. With five years worth of living expenses in liquid investments, you minimize the risk of having to sell stocks in the middle of a bear market. Selling at a loss is a calamity for retirees, who no longer have the time or the earnings to replenish their savings. To be sure, leaving your stocks untouched for five years doesn’t guarantee that you won’t lose money – but if you do, says Evensky, it’s unlikely to be a very big loss.  

Like all good rules of thumb, however, this one comes with a big caveat – a caveat that unfortunately applies to virtually every rule about investing: It doesn't work well if you don't have enough money.

Your cash and short-term bond investments shouldn’t exceed 50% of your total portfolio, says Eleanor Blayney, consumer advocate for the Certified Financial Planner Board of Standards. The reason: At least 50% of your savings have to be invested in stocks and longer-term bonds to ensure your portfolio will last as long as you do. 

If five years of your living expenses equals 80% your portfolio, Blayney says, your savings alone are insufficient to cover those living expenses throughout your retirement. You’ll therefore need to supplement your annual withdrawals with income from other sources, like a part-time job, the equity in your house, and Social Security. And that, of course, is the situation in which most of us can expect to find ourselves.

In my next post, I’ll describe the best practical method I know for taking annual withdrawals from your investment portfolio.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

 

 

 

Retirement Investing: How to Survive this Horribly Choppy Stock Market

Bear with me: I'm still playing catch-up after that 8 day vacation!

Meantime, in lieu of a new blog post, please take a look at my latest article about investing for retirement, which is in the September/October issue of AARP Magazine and is also posted on AARP's website.

It's called 'Five Ways to Prepare for the Next Market Dip' . Of course, that headline is evergreen, but seems to be particularly apt these days! 

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c:) Lynn Brenner, All Rights Reserved

Can I Withdraw My Principal From A Roth IRA in Less Than Five Years Without Triggering a Tax?

Q: I really appreciated your timely AARP magazine article "Roth Mania" . I have a question on one of the rules. You wrote: "Roth IRAs allow tax-free withdrawals of earnings after you're 591/2 and have owned the account for five years." Does this five-year rule refer to the principal and the interest earned, or just to the interest earned? -- PS via email
 
A: This rule is often misunderstood!  It applies only to the interest earned.

You can't withdraw the Roth IRA's earnings tax-free until you're over 59 and a half AND have owned the account for five years. 

But you can withdraw your principal anytime without triggering a tax or a penalty.

There is one exception: If you do a Roth conversion and you're under 59 and a half, you'll owe a 10% early withdrawal penalty -- but no income tax -- on converted principal that you withdraw within five years of doing the conversion, says Barry C. Picker, a New York City tax accountant and IRA expert.

If you do a Roth conversion and you're over 59 and a half, you can withdraw the converted amount tax-free and penalty-free at any time; but you can't withdraw earnings tax-free until the account is over five years old. 

The reason you can withdraw Roth IRA contributions tax-free anytime is that you've already paid taxes on them. If I contribute $2,000 to a Roth IRA, for example, I get no tax deduction for the contribution. The $2,000 is included in my taxable income for the year.

But of course, there's a major downside to tapping the account: If you withdraw your principal, the Roth IRA can't earn anything.

Please send your questions to [email protected]. I'm sorry I can't respond personally to every email. Questions are addressed only online.

(c) Lynn Brenner, All Rights Reserved.