Congratulations, you’ve finally made it to retirement!
You’re ready to live the life of leisure after saving up for your entire working life. You log into your brokerage account, go to withdraw money, and an empty field sits in front of you — how much should you be taking out? How much can you spend in retirement to avoid running out of money? These are important questions that require careful consideration.
Let’s take a look at how to decide how much to spend in retirement to avoid running out of money or failing to meet your other financial objectives.
Deciding on a Withdrawal Rate
Suppose that you have saved up $1 million for retirement by the time you reach 65 years old.
How much can you spend each year?
If you take out too much, you may not have enough left to fund your entire retirement. If you take out too little, you might leave too much money on the table. There’s also the issue of how much you’d like to leave your heirs and accounting for sudden and unexpected expenses that may arise.
There are three strategies that are commonly used for planning out withdrawals.
#1. Four Percent Rule
The most popular withdrawal rate strategy is known as the four percent rule. The rule says that you should withdraw four percent of your retirement portfolio during the first year. The withdrawal amount for subsequent years is the same dollar amount, adjusted for inflation.
In our example, the $1 million retirement portfolio would draw down $40,000 during the first year. If there was three percent inflation the second year, the withdrawal amount would be adjusted to $41,200 — or 40000 x 1.03. The idea is that you would leave the principal $1 million relatively untouched.
You can adjust these withdrawal rates depending on your needs at any given point in time. For example, you may have a medical emergency that requires some extra spending during one year. Keeping the principal in place ensures that you have a rainy day fund in place when you need it.
#2. Income Floor Strategy
Another common strategy is the income floor strategy, whereby you cover essential spending with guaranteed income like Social Security, single premium immediate annuity, or reverse mortgage. That way, you don’t have to sell stock when the market is down or conditions aren’t ideal.
Since this strategy is the most conservative, it requires that you have a substantial amount of money saved up or a compatible budget. The strategy works best for those that contributed a lot to Social Security, but plan to live a simple life during retirement with no outstanding debt.
#3. Custom Calculation
A final strategy involves making highly-customized calculations to determine an appropriate drawdown for your specific situation. These calculators factor in your expected lifespan, spending, risk tolerance and other factors to come up with a withdrawal amount that will deplete the portfolio over time.
You should work with a financial advisor if you’re interested in drawing down your portfolio over time. While there are many online calculators, they miss some of the fundamental questions that you should be asking and you want to ensure that you avoid running out of money at all costs.
What If It’s Not Enough?
Some people don’t have enough saved for retirement after accounting for their retirement portfolio, pension funds and Social Security. The good news is that there are many ways to address the problem. The bad news is that some of these options may not be ideal or easy decisions.
Common ways to shore up retirement funds include:
- Work: The most straightforward way to increase your retirement savings is to keep working. In addition to income, you may also receive health insurance and other benefits to reduce spending and accelerate savings.
- Budgeting: The second most straightforward way to make retirement more affordable is to spend less. Budgeting can help you determine areas where you can cut costs to stretch your retirement dollars over a longer period of time.
- Social Security: You have the option to take Social Security early in order to afford an early retirement. While this will boost your income earlier, it comes at a significant long-term cost that you should carefully consider.
- Investments: Income investments, such as bonds or dividend stocks, can generate investment income rather than relying exclusively on withdrawals to fund retirement. The catch is that some income investments reduce capital gains potential.
- Downsizing: Selling your house and moving into a smaller house or a house in a more affordable area can help you pocket extra money for retirement. These funds can be invested in income-producing assets.
The Snider Investment Method helps you generate an income by writing call options against a portfolio of high-quality stocks. In essence, you can generate greater yield than a portfolio of dividend stocks while still benefiting from the potential upside of the stock market.
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It’s important to note that there are pros and cons involved with each of these strategies. You should consult a trusted financial advisor to discuss the options since they can help you understand all of the risks and decide on the best course of action to achieve your financial goals.
The Bottom Line
The first question that many new retirees face is: How much can I afford to spend in retirement? The answer to that question depends on many different factors, but the four percent rule is a great starting point. Strategies like the Snider Investment Method can push the 4% rule even higher. There are also many ways to shore up retirement funds if you’re behind.