When it comes withdrawing a “paycheck” from their retirement savings, many retirees say they prefer not to spend “principal.” However, capital gains are an important source of return—and potential cash flow—so it makes sense to have a broader conception of income. Below are some things to consider when it comes to creating your own retirement income from your portfolio.
- Dividends and interest versus selling shares. Over time, your annual portfolio withdrawals will likely come from taking a total return approach—that is, a combination of interest, dividends, and proceeds from the sale of appreciated assets. For example, if you have a moderately-conservative target asset allocation (40% stocks, 50% bonds and 10% cash), you might expect an average annual total return of around 5%. As a result, your withdrawal for the year might consist of interest and dividends, as well as capital gains and principal, because interest and dividends alone might not be enough to cover your annual spending needs.
- Which investments should you sell? One reasonable approach is to take care of your cash flow needs a few times a year as you rebalance your portfolio back to your target asset allocation. As you reallocate your assets, you can take out the cash you need. For example, if your target allocation is 40% stocks and 50% bonds—but your portfolio drifted to 45% stocks and 45% bonds—you could sell a portion of your stock allocation and hold the cash proceeds from annual spending.
- Bonds maturing in the coming year. If you own individual bonds, consider those maturing within the next 12 months as part of your current-year cash flow, before liquidating other assets at a taxable gain. If you’re holding such bonds in a taxable account, you shouldn’t have to worry about unrealized capital gains, as any gains are likely to be relatively small.
- Taxable versus tax-deferred accounts. In general, it’s typically better to sell long-term investments held in taxable accounts instead of taking money from tax-deferred accounts before you have to. Withdrawals from traditional IRAs and 401(k)s are taxed as ordinary income—typically at a higher rate than the preferential long-term capital gains rate. What’s more, tapping your IRA or 401(K) early means losing opportunities for tax-deferred compound growth. However, there are possible exceptions to this general rule: If your IRA or 401(K) balance is very large, you may want to draw from it before the age of 70½, when the required minimum distributions (RMDs) begin. A sound tax-management strategy may be to start IRA distributions earlier to smooth out your tax bill.
For estate-planning purposes, your taxable estate includes your IRA balance and your heirs will owe income tax on any distributions they take from your IRA. Drawing down your IRA during your lifetime and leaving taxable accounts to heirs could be an effective strategy. If you have both a traditional IRA and a Roth IRA, consider drawing from the traditional IRA first. The Roth is still included in your taxable estate, but at least your beneficiaries will be able to take distributions tax-free. Distributions from a Roth IRA are tax-free if you take them in retirement as well. If you had the foresight to accumulate savings in a Roth, it gives you flexibility to balance withdrawals between traditional brokerage accounts, traditional IRAs and Roth IRAs as needed.
Finding the most tax-efficient withdrawal strategy can be challenging. In order to optimize your retirement income, it may be beneficial to work with a financial or tax professional to create the most efficient strategy for you.