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Three Tips on Retirement Drawdown Strategies

Retired couple looking at the water

Authored by: James DiLellio, PhD, Associate Professor of Decision Sciences at Pepperdine Graziadio Business School. 

As individuals enter the retirement phase of their lives, they often face a myriad of decisions on how to support their retirement income goals from a variety of sources. But, how can these drawdowns be done efficiently, thereby extending the longevity of a portfolio or increasing funds passed to your heirs?  Nobel Laureate Bill Sharpe described efficient retirement drawdowns as “one of the most difficult financial problems” he has ever attempted. 

There are many sources of income to fund retirement needs, including social security, pensions, 401(k)s, Roth IRAs, taxable savings, and possibly others.  Additionally, retirees are living longer, so their retirement income plan must last for 30-40 years, during which uncertainty in investment returns, taxes, and inflation can all have significant consequences.  Longer retirements mean individuals have to rethink how they will drawdown money from their retirement. So, how should a retiree plan for retirement that may fall in uncertain times? Here are three strategies to consider when planning your retirement income approach:

1. Social Security

With few exceptions, many of us will receive some amount of social security income.  But we must decide when to start receiving it, which must occur between ages 62 and 70.  Since the US Government keeps track of life expectancy, it is not surprising that retirees will receive smaller monthly social security payments if they begin drawing down social security at a younger age.  If you simply wish to maximize your retirement income from social security, then a retiree who expects to live longer than their peers should delay starting social security.  Alternatively, retirees in poorer health that may wish to start their social security payments sooner, must recognize their monthly payments will be reduced. 

2. Tax-deferred account (TDA) and tax-exempt account (TEA) income 

Tax-deferred accounts include 401(k)s, 403(b)s, and traditional IRAs funded with deductible contributions.   With these accounts, retirees must take care to draw them down steadily and early in their retirement. Why? Required minimum distributions (RMDs) could drastically increase taxable income and push an individual’s taxable income into the higher tax brackets.  In recent research I conducted with Dan Ostrov at Santa Clara University, we show that TDA income should be steady year-over-year, and should avoid spikes in any year’s income from a TDA.  To make up for any shortfall in income needs, individuals should use social security, pensions, and tax-free TEA funds.  The TEA funds can also serve as an excellent funding source in the event taxes rise in the future, since all TEA account drawdowns are tax-free, provided they begin after the retiree turns 59 ½ years old.

3. Your heir’s tax rate

If you anticipate that your heir will receive an inheritance, retirement income planning should consider your heir’s tax rate.  Why?  Because the TDA account will be taxed at some point, either by you or your heir.  So, to increase their bequest, TDAs drawdowns should only occur up to the point when they trigger less tax than your heir.  For example, if your heir is an adult child who earns a high income (e.g., a surgeon or investment banker), putting them into the highest income tax bracket, the retiree may drawdown the TDA up to this tax bracket each year.  Conversely, if your heir is a lower wage earner, then you should consider avoiding larger TDA drawdowns that trigger higher taxes since comparable drawdowns by your heir would be more tax efficient.  In the extreme, if your heir is a charitable organization, then a retiree should minimize the TDA drawdowns since the charitable organization will receive the TDA funds tax-free. 

Too much complexity?

Large brokerages, like Fidelity and Vanguard, navigate through the complexity of efficient retirement drawdowns by recommending a sequence called the Common Rule:

  1. RMDs from 401(k)s, 403(b)s, and IRAs
  2. Drawdown taxable accounts until they are exhausted 
  3. Drawdown TDAs until they are exhausted
  4. Drawdown TEAs until they are exhausted. 

However, I’ve shown in prior research that the use of the Common Rule is tax-inefficient by either several years of portfolio longevity or significantly more assets bequeathed to an heir.  Using my free online calculator, one can see how Modified Common Rules can offer significant benefits.  

While living longer and having a longer retirement is fantastic news, individuals must plan accordingly and ensure they have the money needed to live and do everything they want during retirement. Individuals that plan appropriately and make a few smart decisions early in the retirement process can have significant benefits on their estate’s value and for your heirs.