In 1978, 401k plans were enacted into law and have become a popular savings option for millions of Americans. The rise in popularity of 401ks coincided with a decrease in defined benefit pensions provided by employers. These plans, along with similar defined contribution plans, have many attractive benefits like automatic payroll deduction for contributions, employer match arrangements, and the ability to defer taxes on the monies in the account.
As millions of baby boomers retire, most are wondering, “What am I supposed to do with my 401k?” It’s an important question because most participants have a majority of their accumulated assets in this type of retirement account. Because of its convenience, some people have nearly all of their nest egg in government-sponsored or qualified plans.
The common answer in the financial services industry is to move your 401k into an IRA. Okay, but IRAs can take many forms and offer significantly more choices than employer-based plans. IRA monies can be invested in simple savings accounts, CDs, bonds, annuities, mutual funds, stocks and even real estate. As one might imagine given the array of choices, not all IRAs are created equally.
Where to Start?
Pre-retirees and retirees should consider the “purpose” of the money they’ve saved. In other words, how do you plan on using the money? During the accumulation years, most account holders have become account statement admirers and are mostly untrained on how to turn accumulated wealth into something tangible, like vacations and mortgage payments. I recommend segregating your assets into two basic categories: After-tax liquid monies (non-qualified and Roth savings) and tax-deferred assets (pensions, employer plans). The liquid monies are the most flexible assets in retirement for spending because the IRS has limited control on them.
Meanwhile, the qualified assets, including 401ks, are significantly less liquid. One gentleman replied to this thought by saying, “How is my $250,000 IRA not liquid? I could spend it if I wanted to.” Yet, we considered the implications of treating the $250,000 as a truly liquid asset. The client understood taxes had to be paid on the withdrawal, so we “bought” a $175,000 vacation home to account for the deduction. Sounds great, except the IRS has a second, often forgotten rule: Withdrawals from qualified retirement accounts count as income. In other words, the client’s $250,000 withdrawal put him in the highest income tax bracket when considering the other money he needed to pay the bills. He would have to pay over 45% in taxes on the $250,000 and on his other retirement income. He quickly agreed his money was not “liquid” like the money he has in his bank account. Because of this dynamic, retirement monies have one real purpose: To be used as retirement income.
How Much Income?
What is a reasonable amount of money to withdraw from your retirement account? This is a question many experts have tried to answer for years. The following is a list of the most common answers:
Growth or Interest: Some investment managers recommend withdrawing “only” the growth of your nest egg.
Market Simulation: Others use computer simulation programs like “Monte Carlo” to guess the amount of income that can be withdrawn from an investment qualified plan.
4% Rule: There is also the popular 4% rule. The 4% rule, as the name implies, suggests taking 4% of the account balance as income each year.
Conservative Approach: Some retirees buck all of the above recommendations and only try to withdraw the minimum amount of money. Using this approach, the money would not be touched until age 70 1/2, and then only required minimum distributions would be withdrawn.
Why are there so many approaches? Well, the retirement years are full of unknowns, including health care costs, inflation, market volatility, tax changes, longevity and interest rate changes. Retirees are most vulnerable to these unknowns because they no longer earn an income from employment. Retirees must withdraw their money without running out.
There is a problem with each of the approaches mentioned above. What does someone do under the first scenario when the market has negative years? Spend into principal or live on pennies? Meanwhile, market simulations often require retirees to expose a majority of their assets to total market loss. The 4% rule would require retirees to save millions of dollars to have a reasonable retirement. How much money would someone need to save to have an income of $75,000 in retirement? According to the 4% rule, the answer is $1.87 million. How does the 4% rule account for inflation? Where can someone earn a consistent return of 4% every year? Considering the overwhelming weaknesses of the options, it’s no wonder some have thrown in the towel with the conservative option.
Here’s the deal: The only way to take full advantage of one’s employer account is to start withdrawals as soon as possible and continue the withdrawals until death. These withdrawals should start near the beginning of retirement, even if the money is not needed for income. Why? Withdrawals from qualified monies are most efficient when drawn out as steady streams of income over a long period of time versus large withdrawals. Meanwhile, if the monies grow throughout retirement, then the taxes will compound for beneficiaries (who are often the children of retirees). Imagine the unintended consequence. Parents would defer taxes from their income, not use the monies effectively in retirement, and pass their income taxes to their kids. The kids then have the burden, through inherited IRA required minimum distributions, of paying the parents income taxes the same time they are hitting their income potential as adults. Was that the goal? No way.
Instead, the qualified monies should be withdrawn for income near the start of retirement. If one does not “need” the money, then it’s okay to pay the taxes at a lower tax rate and save the money. The idea is to filter the money through the IRS in a way that offers flexibility during retirement while minimizing the negative consequences for beneficiaries.
One of the most effective ways of withdrawing money from 401k plans and rollover IRAs is through the use of phased withdrawal strategies, laddered annuities, and the use of annuity withdrawal benefit riders. Each of these options allow for a more effective withdrawal rate than the common approaches above, without the risks associated with the alternatives, and guarantees against running out of money before death. It’s important to understand how much money is needed for purchases “beyond the budget” for health care and large purchases (cars, home related expenses, kids). The other money should be put into to IRAs that best accommodate a sound withdrawal strategy. The goal is to create the largest stream of income over the longest period of time with protection against running out.
For more information on what to do with your 401k, call Winter Troxel and Monumental Financial Group at 301-569-6941 or visit www.monumentalfinancial.com.
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