Written by Hi, it’s Dre Griggs with Obsidian Wisdom. Today, we answer the question, What are the best withdrawal strategies for my retirement? As you have been accumulating your wealth, you’ve been building wealth over the years so that you could stop working. That is what we call retirement. I am unemployed, but I’m not broke. Which is a nice change from when we were unemployed, when we were younger, but we were also broke, so we couldn’t spend any money because we didn’t have any to spend.
Flexibility and Freedom
Retirement is supposed to be the time where you stop working and you have the same amount of freedom that you used to have. The freedom that my kids have when they come home from school, they finish their homework where they decide to go outside, they play, they have a good time. Or maybe when you were in college and you seem like you just had a couple of classes here. A couple of classes there.
Yeah, you may have had a job where you did some work, but you realize you had a lot more freedom at those points in your life. You just didn’t have a lot of flexibility with your freedom. Where I have the freedom, I have the ability to do certain things, but the financial constraints that are keeping me from being able to do it are sort of holding me back.
And that is when we usually make the decision, you know what? I’m going to go ahead and just go into this workforce. I’m going to figure this thing out. It’s obviously cost a little bit more than I thought it did to be free. So let me go out and purchase my freedom. And then we make certain decisions along the way, and some are good and some less than stellar.
What does happiness look like?
Then eventually we figure out exactly what happiness looks like. And then depending on how deep of a hole we got to climb out of, is basically the plan that we put together so that we can live a life full of success, happiness, and wealth. As you come to the very end, we’re at the point where you’re like, okay, I’m here. I got the money. What do I do with my bag?
Today we’ll talk about five different withdrawal strategies, and today you’ll be able to decide which one makes the most sense for you. Oftentimes you’ll see that it depends a lot on your financial situation. But we’ll go through that.
1. Percentage matches return withdrawal strategy
If you have a set percentage, so some people often will say 4%. I often say that’s fine, but it generally depends on what your return is. Ideally, the amount that you take out is the same amount that you are putting in as far as your money working for you. If your money gives you a 4% return every year, then taking out 4% sounds like a great idea.
If your money generates 2% every year and you take out 4%, it doesn’t sound like as good of an idea. So it depends a lot on what your returns are. Now, you don’t want to just take all of your money out of all equities where you’re leaving yourself without the ability to even keep up with inflation, but you don’t want to leave yourself in the market. Where you stand the chance of losing a significant amount of money. Where you don’t have the ability to make it back over the long term.
Avoid speed traps
Because as you’re retiring, you’re not going to be keeping your money in the same investments over that long period of time. I often equate it to when I’m driving. When I’m driving long distances. I generally don’t want to take that risk of getting a ticket right before I’m at my exit. It’s not going to save me that much time if I speed for the last 30 minutes. But if I drive the speed limit, then I know that, okay, I’ve done the trip. I’m already at my exit just about, and if I just drive the speed limit the rest of the way, then I know that there’s no chance that I’m going to get a ticket.
And it may seem like it’s a more reasonable risk at the beginning of the trip. Because I have four hours to drive, or I have seven hours to drive, or 10 hours to drive. So speeding at the beginning, it just seems like, well, I can save a lot of time. If I was to drive this speed limit for the next three hours, I’m going to save a significant amount of my time on the trip.
All risk is not equal
So the big takeaway is all risk isn’t created equal. The closer you get to your exit, the safer you should be. There’s no reason for you to take the risk of possibly getting that ticket when you only had another 20, 30 minutes left. The same is true with retirement. There’s no reason to take a significant amount of risk when you’re right at the finish line. You’re not going to be making a significant amount more over the next year to five as you get closer to retirement.
And so I often will tell people kind of the same thing. As you’re near retirement, you would want to make sure that you’re pulling so of your money out of the equity, and maybe into some safer things. We shift to what’s called capital preservation, which just means I make sure my money doesn’t go anywhere.
2. Three bucket withdrawal strategy
The second strategy helps you with that, and that’s the bucket strategy. You often hear people talk about putting your money in three buckets.
Daily Expenses Bucket
The first bucket is going to be your three to five years of living expenses. So you would have to calculate how much your living expenses are. If you have a financial plan, then you already know what that is, and if you have an emergency fund, then you should have an idea of what that is as well.
Three to five years of living expenses that goes in essentially cash. Like you’re not really putting that money at risk at all. That’s what you’re going to live off of, when you go to fill up your gas tank, and food and pay your bills.
Moderate Risk Bucket
Then the second bucket is your moderate risk, where it’s not that much, but you’re able to get a decent return where you’re hopefully keeping up with inflation.
This amount is normally gonna be in something that’s a fixed income, like bonds and different things. Where you would think of money, market accounts, things like that is gonna be in the middle bucket.
Aggressive bucket
Then the third bucket is going to be your equities. That’s going to be the money that you leave to be aggressive.
That’s the money that we want to continue growing. What you’ll do is you’ll live off of the first bucket, and as the first bucket gets smaller, you’ll replenish that bucket with your second and third bucket. That leaves your money in the market a little bit longer, and it also gives you a little bit of flexibility.
To where if your bonds aren’t doing that well, then you can leave those there because you don’t want to lock in the losses. And you can take the money from some of your equities and fill up your daily cash bucket. The opposite is also true. Where if you’re not comfortable with the way the stock market and the volatility is, you can leave that money there for it to continue growing for a better opportunity, and then you can take the money out of your bonds. To where you have this flexibility, where you’re not locking your losses, but you’re also not disturbing your, your overall living.
Within that three to five year range. The reason we say that is you would look at the third year and the fourth and the fifth, and whenever you find a good opportunity to replenish your cash bucket, you’re going to take advantage of that opportunity over that three to five year range.
3. 4% Plus Some Rule
The third withdrawal strategy is my 4% plus some rule. The way it works is if you had a million dollars and then 4% of that would’ve been $40,000, and you would say, Okay, I’m going to live off of $40,000 a year. And then if that matches with the expenses where you can maintain that. All you would do from there is you would take that $40,000 and then you would add 2% onto that each year.
That way you can keep up with inflation. So the way it would work is, let’s say you had a million dollars in your portfolio and you wanted to live off of 4%, you would then save 4% of $1 million is 40,000. In the first year you would live off of $40,000. The next year you would just add 2% onto that $40,000.
So 2% of $40,000 is $800. So the second year you would have $40,800. That’s what you would live off of, and you would just keep doing that, assuming that you’re going to be able to keep up with inflation. Ideally, some years inflation will be a little bit lower than that. Some years inflation will be higher than that, but you will average around that 2% so that you’re able to stay relatively close to the same purchasing power. Which just a very fancy way of saying you can still afford everything that you used to be able to buy with your money.
4. Income withdrawal strategies
The fourth strategy is for you to live off of your income. If you set your investments up in a way where you’re generating an income through dividends or interest, you would just live off of the dividends and interests.
This strategy works very well for people who want to make sure that they have a legacy to be able to pass on to their loved ones. And they’ve also have enough money naturally, that is being generated through their dividends and their interest to where they have that money coming back to them. In some situations, if you haven’t already set some of your money in dividends and interest to where you’re generating an income, if you’re income driven and that would be the best withdrawal strategy for you, then it may make sense for you to get a fixed annuity. Where it doesn’t have all the bells and whistles and all the extra fees associated with it.
Set up the withdrawal strategy
But it does have a set amount of money that it gives you every single month or every single year. However, you set it up for the withdrawal. And maybe you can take a portion of your money from your investments and you can put that in the annuity, and then that annuity will pay the rest of your life. For those who are concerned about their investments in the stock market, the annuity is nice because it gives them a fixed amount of money every single year, and it doesn’t change.
Now, the difference is the insurance company is the one that’s on hook with the risk. It becomes their job to take your money and make a larger return than what they guaranteed for you. And generally they are able to do that. That’s why they stay in business. Generally, the focus of the annuity is to make sure that your needs are taken care of, where you have the money that’s coming in to keep the lights on, to keep the water running, and to keep the food in the refrigerator.
5. Fixed percentage withdrawal strategy
Our fifth and final strategy is a fixed percentage. Whatever your overall portfolio is worth, let’s say it’s worth a million dollars this year, you would take 4% out this year. If for some reason it jumped up to $2 million next year, then you would still take out 4% next year. The difference is you would have $40,000 to spend this year on the 4%, and you would have $80,000 to spend next year with the same 4%.
If the portfolio dropped where it went from a million dollars to $500,000 over the year, then you would still spend the same 4%. Just this year you would be living on $20,000. Some people like the fixed percentage because they know that that means that they’re keeping up with the overall growth of their portfolio, where they’re just spending what is being grown each year.
But some people don’t like it because you’re not going to be having the same amount of money every year. Sometimes it’s going to go up, sometimes it’s going to go down, it may go up a little bit, maybe down a little bit, and it, it does make people a little uncomfortable. It really depends a lot on the overall person.
Final thoughts
Ideally, you want to be able to combine a couple of these. Usually that works best for most people. When you take a step back as far as just tax considerations, most tax experts would say you want to start with the money that is going to be tax first. Then you take out the money that is tax deferred second, and then you have your tax free money third.
There is some debate within different groups on whether you should start with the tax first or the tax deferred first, but everybody agrees the tax free money should be the one that you do last your tax free money. Allow it to grow, allow it to become something large, and if you never have to use it, then it’s a great legacy plan that you can leave behind.
And if you do have to use it, at least you’ve allowed that money to grow as much as it could without having to pay any additional taxes on the growth or the withdrawals of it. Depending on your overall age when you retire and the income that you had, that will usually decide whether it makes the most sense for you to start with your tax deferred account or your taxed account.
So your taxed account is just your overall investments money that you have in your brokerage account, and then your tax deferred account would be like a 401(k), 403(b). Anything that the tax is being deferred. And the reason it depends a lot is if you’re deferring taxes from a historically low tax period as we are today, you may be setting yourself up for a higher tax bill in the future.
You also have to take into consideration with the tax deferred accounts whether you’re starting too early. Everybody that I work with is not retiring after 59 1/2 Some people are retiring in their thirties and their forties. If you’re retiring in your thirties and your forties, then you cannot touch your tax deferred accounts before 59 1/2 without a penalty.
Good ole Uncle Sam
Ideally, you don’t want to have to pay Uncle Sam any sort of a penalty, so you would want to not touch that account until after you’re 59 1/2. So it would make the most sense for you to start with your taxed accounts. Just the money you have in your investments. For others, maybe you work so late and so long that you are within what’s called the required minimum distribution.
Where Uncle Sam has a pretty hefty tax if you don’t start taking the money out of your tax deferred accounts. So it may make the most sense for you to start with your tax deferred accounts because you don’t want Uncle Sam taking any extra money because you’re not using it. Where he’s just getting so antsy about his tax money, he’s tired of it being deferred, and he wants you to start realizing some of those taxes so he can take his money.
Then it would make sense if you’re older and you retired later to start with your required minimum distributions.