After years of saving up for retirement, there will come a time when you need to start spending your nest egg. Drawing down your assets in an appropriate way can be just as crucial to your retirement security as saving and investing. Here are some risks to avoid when spending your retirement savings:
Losses in retirement are especially problematic. You annual returns start to be very important in the years leading up to and immediately after retirement. When you are saving up for retirement, it’s certainly better to get a 15 percent return than a 5 percent return or a loss, but over a 30-year career the returns of a single year won’t make or break your retirement. However, returns make a much bigger difference once you start taking withdrawals from your investments, especially if you experience a decline it the early part of your retirement.
A few big declines in the first few years of retirement on top of yearly withdrawals can deplete your nest egg so much that the remaining portfolio can never recover. For example, consider an investor with 100 percent of his assets invested in the S&P 500 index at the beginning of 2000. If no withdrawals are taken, the investor would have roughly 62 percent of his nest egg at the end of 2002 and fully recover sometime in 2007. However, the recovery is much worse for a retiree withdrawing $50,000 a year. By 2002, just 50 percent of the portfolio is left. And even by 2007 he would only be left with 63 percent of the original amount. And this calculation does not account for taxes. Add a bit of tax costs and the picture is even bleaker.
To avoid significant losses in retirement, many retirees shift their retirement money to more conservative investments that are less likely to lose value. While the growth might be slower, conservative investors are also less likely to suffer a financial setback they don’t have time to recover from.
Debt is even more costly for retirees. It will be easier on your nest egg if you pay off debt aggressively before retirement, including your mortgage. Eliminating debt will allow you to significantly lower your retirement expenses and withdraw less from your savings each month, giving your money more time to grow. While mortgage rates do seem lower than the annualized returns of the market, it's not a sure bet you'll win financially after you account for the fact that money has to be taken out every month from a volatile market to pay for the principal plus interest owed on the loan. Taking additional money out of savings to cover debt payments each month in a volatile market can stress the portfolio too much.
Minimizing taxes is essential in retirement. Tax strategies may make an even bigger difference to your bottom line during retirement than they did while working. Retirees have many opportunities to save money on taxes because many of their income sources are no longer taxed at ordinary rates. Only part of your Social Security payments will be taxable, and the amount that is taxable depends on your income. When deciding when to claim Social Security, it’s important to determine how taxes impact the calculations. Some retirees will come out ahead by holding off on starting Social Security checks until they convert pre-tax assets to a Roth IRA. While income tax is due on a Roth IRA conversion, if you make the conversion in a year when you don’t have any other income you will typically pay a lower tax rate than if you convert while working or claiming Social Security benefits.
However, it’s also useful to keep some money in taxable, pre- and post-tax accounts, and then each year in retirement you can determine the most tax-effective way to draw the income you need from these three types of accounts. You must pay income tax on withdrawals from pre-tax accounts, while Roth distributions in retirement are typically tax-free. It’s important to weigh the tax consequences of each withdrawal to make sure you aren’t paying more to Uncle Sam than you need to.
Take some time to consider the lasting effects of the retirement decisions you make. You have several opportunities in the decumulation stage to make your money last much longer. And if you don't end up spending it all, your heirs will thank you for the financial moves you make now.