- Retirement is when you transition from the accumulation phase to the distribution phase.
- Having a proper 401K withdrawal strategy could mean the difference between a comfortable retirement or a financially stressful one.
- I’ll show you a strategy that can weather a stock market decline (especially given today’s overvalued market), yet generate consistent high monthly income + maintain principal.
What you will learn:
- I’ll start with well-known recommended 401K withdrawal strategies – and why it doesn’t work in today’s markets.
- I will then share my recommended strategy to reduce risk, while generating high monthly income in retirement, plus maintaining your principal.
Why a proper 401K withdrawal strategy is critical.
As you can see below, retirees in 2006,2007 lost about 38% of their nest egg in 1 year on seemingly the safest of investments (target date funds). It then took 10+ years to recover their losses. With parallel’s of 2008, the stock market is dangerously high today, so downside protection in any investments is critical.
When do I have to start making withdrawals from my IRA?
Generally, you’re required to start taking withdrawals from your traditional IRA when you reach age 70 ½ (unless you’re still working, under some plans). Roth IRAs, however, don’t require withdrawals until the owner of the account dies.
With a 401(k), you can start to make penalty-free withdrawals when you turn 59 ½.
When do I have to start making withdrawals from my 401(k)?
You’re required to start taking RMDs from your 401(k) when you reach age 70 ½ (unless you’re still working, under some plans). Once you start taking RMDs, your withdrawals will be taxed as ordinary income.
Existing Retirement withdrawal strategies (and why they don’t work)
Below are the popular withdrawal strategies most recommended by financial advisors.
The 4% withdrawal rule
The 4% rule is when you withdraw 4% of your retirement savings in your first year of retirement. In subsequent years, tack on an additional 2% to adjust for inflation.
For example, if you have $1 million saved under this strategy, you would withdraw $40,000 during your first year in retirement. The second year, you would take out $40,800 (the original amount plus 2%). In the third year, you would withdraw $41,616 (the previous year’s amount, plus 2%), and so on.
Pros: This has been a longstanding retirement withdrawal strategy. Many retirees value this strategy because it’s simple to follow and gives you a predictable amount of income each year.
Cons: It does not consider the effects of rising interest rates and market volatility. If you retire at the onset of a steep stock market decline, you risk depleting your savings early and running out of money.
Fixed Dollar WithdrawalsSome retirees take out a fixed dollar amount over a specific period of time. For example, you might decide to withdraw $40,000 annually – no matter what.
Potential advantages: This approach can simplify your personal money management.
Potential disadvantages: This approach doesn’t protect against inflation; for example, $40,000 may not have the same purchasing power from one year to the next. Additionally, in a down market, you may have to liquidate more assets to meet your fixed-dollar withdrawal.
The systematic withdrawal plan
In a systematic withdrawal plan, you only withdraw the income (such as dividends or interest) created by the underlying investments in your portfolio. Because your principal remains intact, this is designed to prevent you from running out of money and may afford you the potential to grow your investments over time, while still providing retirement income.
Potential advantages: This approach only touches the income – not your principal – so your portfolio maintains the potential to grow.
Potential disadvantages: You need to find investments that generate high monthly income, with low risk – which is very hard to do, especially in today’s overvalued stock market.
The Bucket Strategy
With the “buckets” strategy, you withdraw assets from three “buckets,” or separate types of accounts holding your assets.
Under this strategy, the first bucket holds some percentage of your savings in cash (no risk): often three to five years of living expenses. The second holds fixed income (medium risk). The third bucket contains your remaining investments in stocks (high risk). As you use the cash from the first bucket, you replenish it with earnings from the second and third buckets.
Potential advantages: If done right, it allows your savings to grow over time.
Potential disadvantages: Your returns may be quite low since your first 2 buckets (for 10 years) hold a mix of cash and fixed income (returning 1-2% in today’s markets). Your third bucket may also drop due to a stock market downturn (especially in today’s overvalued market).
My Recommended Strategy
My recommended strategy – and the one I use for my own personal portfolio is a mix of the systematic 401k withdrawal strategy and the bucket strategy.
Here’s how it works:
- In general – I only live off the interest and dividend income on my savings. I want to leave the principal untouched, so it can grow over time.
- I use the bucket strategy – but with some tweaks:
Bucket Strategy Advisors recommend (example $500,000 portfolio):
|Bucket Numbers||Years||Amount||Problem with this approach|
|1||1-2 years||$25,000 (cash)||Collects no interest|
|2||3-10 years||$200,000 (fixed income, bonds)||Returns 1-2%|
|3||10+ years||$275,000 (stocks)||What if the market drops 50% (likely scenario)?|
Problems with above strategy:
Very high chance of running out of money quickly. Cash earns nothing, fixed income earns 1-2% in today’s rates, 3rd bucket of stocks could drop 50% given the overvalued stock market.
My recommended strategy (example $500,000 portfolio)
|Bucket Numbers||Years||Amount||Why this works|
|1||1st year||$25,000 (cash)||Safe for spending|
|2||2nd year||$25,000 (fixed income, safe, earns 1.3% e.g. VMBS)||Every year, move to bucket 1|
|3||3rd year onwards||$450,000 (7% yield + downside protection + some growth)||Every year, take dividend income money from this bucket (~$32,000) and move it to bucket 2.
Done right, you should never have to touch your principal.
- The above strategy is safe, even if the market drops.
- Done right, you do not have to touch your principal, only live off the interest.
- The key here is to find an investment providing high monthly income (7%+), low risk, growth AND downside protection for your third bucket. This is very hard to find – but they do exist.
- In fact, there is a NEW investment created by a top tier financial firm that is actively managed, has downside protection, provides monthly income (7%+) AND has low fees – perfect for a set-it-and-forget-it plan for retirees. You can read more about it here.
Summary and Takeaway
- First, look at all the resources for 401K withdrawal strategy for early retirement
- Having a solid retirement income plan (independent of stock market volatility) is critical to a stress-free retirement.
- Follow a strategy (like above) that only requires you to live off dividends, so your principal can continue to grow and you never run out of money.