Taking too much money out of your retirement accounts too soon could be dangerous.
When you enter into retirement, you are going to have to start taking money out of your 401(k) or other investment accounts. This requires a huge mindset shift, since you’ve been building these accounts up your whole life. And you need to be smart about when and how much you withdraw.
Before you start taking account distributions, there’s one key thing you absolutely must do first.
Take this step before taking money out of your retirement account
Prior to making any withdrawals from your retirement savings, you need to set a safe withdrawal rate. This is basically an amount of money that you can take from your investment accounts without taking a huge risk that you will drain your account dry too soon.
See, you are going to need to rely on your retirement investments throughout the entirety of your senior years. You cannot live on Social Security benefits alone without supplementary savings. It’s not possible since Social Security replaces only 40% of pre-retirement income, and you need to replace around 70% to 80% of what you were earning before you left the workforce. Social Security benefits are also seeing their value decline over time, so you will need your savings even more later in life. This is happening because the benefits increases built into Social Security don’t work very well to account for the inflation seniors are experiencing.
If you take too much money out of your retirement accounts too quickly, you will not have enough money remaining invested in income-producing assets. Your returns will start to drop, so your account balance will shrink even more with each withdrawal. Eventually, you could end up with $0.
Setting a safe withdrawal rate helps to reduce the chances of that occurring. You’ll still have plenty of money working for you and earning returns if you limit how much you take out at once. If, say, you can earn 7% per year in returns and you only take out 4% or 5% of your account balance, then you won’t see the total value of your account decline even while taking money out.
How can you set a safe withdrawal rate?
In an ideal world, you would be able to live only off the interest that you earn and would be able to avoid reducing your principal balance at all. But this often doesn’t work in practice.
Seniors tend to need to invest conservatively because they can’t afford to risk big losses if the market declines. They may not be able to wait for a recovery if they have too much exposure to stocks. And even if you earn generous returns in some years, there may be years when you don’t and you’ll still need to rely on your savings to provide income.
This means you’ll need a different withdrawal strategy.
One common rule that seniors follow is to take 4% out of their retirement accounts during the first year of retirement and then increase their withdrawals according to inflation each year. While the chances of running out of money used to be pretty small with this approach, lower projected future returns and longer life expectancies have made the so-called 4% rule more dangerous to follow.
The Center for Retirement Research recommends an alternative approach: using the Required Minimum Distribution (RMD) tables established by the IRS for calculating 401(k) withdrawals to determine how much to take out of all your accounts — even if you aren’t yet required to take RMDs.
You can also work with a financial advisor to develop a personalized approach that works for you given your age, risk tolerance, life span, and the amount you have invested to support yourself. Whatever you do, though, don’t take money out until you’ve decided how much you can comfortably afford to withdraw, or you could really end up regretting it.
