I am a big fan of people helping people as practiced by contributors in SA. Many of the topics discussed here have added to my education and income. However, one issue that I have not seen discussed is how to manage cash at retirement. I hope this article will generate some discussion that may help others prepare to manage withdrawals from 401k's and IRA's and thereby preserve hard earned income.
As a fairly recent retiree, I learned the hard way that preparations before reaching retirement as well as judicious use of both contributory and non-taxable accounts at retirement means more cash. My first lesson on managing withdrawals actually occurred while preparing our taxes during the third year of retirement. For the first two years we did not have a state or federal tax bill. However, in the third year, we had taken an additional withdrawal of $2000 from the IRA without realizing that it put us over an income threshold triggering a tax on 50% of my social security benefit. Not catastrophic, but a bite that was not in the budget. This is when I became aware that better planning and proper allocation of assets could have helped me manage cash more effectively.
Some concerns that I should have paid more attention to before retirement that impact cash flow later:
- Waiting until close to retirement to consider converting to a Roth may be too late
- Planned withdrawals from a 401k and a contributory account will minimize taxable income during retirement (unplanned means paying unnecessary taxes)
- Withdrawals from an IRA can lead to paying tax on social security benefits (but can be avoided)
- Planned withdrawals will reduce the risk of liquidating assets during negative market conditions.
- Cash in a money market, while offering liquidity, is not keeping pace with inflation nor earning much interest
Managing cash during retirement means to me avoiding undue taxes, earning interest, liquidity, and maintaining the investment income stream by avoiding painful selling during times of negative market conditions.
One option to consider to manage cash at retirement is the conversion of a 401k to a Roth. For me, after comparing the tax consequences and benefits, that option did not work. Had I investigated this much earlier, the benefits could have been substantial.
Another option for managing cash is managing the tax bill. Since withdrawals from an IRA are taxed as income, setting up the appropriate contributory accounts along with the IRA can avoid a state and federal tax bill for years after retirement. Here is the approach we took that may work for others. Ten years before retirement, we established a contributory (taxable) account with Vanguard. Each month we invested part of our retirement savings in this account. When we were fortunate enough to have a modest profit on the sale of a house, we added that money to the account. With the income and appreciation over the years, we had enough funds in the account (along with pension and SS) to cover about four years of expenses at retirement. Here are the payoffs for us. 1) Since withdrawals from the contributory account are not considered income, that allows us to make withdrawals from the IRA and as long as we keep them under the minimum tax level, we pay no tax on the withdrawal. These funds are added to the contributory account to prolong the life of that account. 2) The funds in the contributory account mean that we do not need to tap investments in a down market to cover our expenses. (I periodically convert holdings to cash in up markets to maintain a safe reserve) 3) The cash sitting in an income producing account rather than languishing in a puny money market.
One of the lessons learned from reading SA articles is that I could have improved on our approach in at least one way (I hope this article will help point out the many other ways that haven't been touched on.) By buying equities and funds in the Vanguard contributory account, I paid annual taxes on capital gains and interest. If I could go back, I would have chosen a Muni fund that would have been exempt from taxes. For example, MZA is an Arizona muni that pays 6.2%, .0695/month and is exempt from both state (where we live) and federal tax. While the bond markets are being crushed today, the historical returns have been constant. Another muni that has been suggested on SA is the Pimco Muni II PML. It also has had consistent long term returns and is currently paying 6.6%.
I've always been a DYI guy around the house and that has carried over into investing. That approach comes with a lot of mistakes and a steep learning curve. I hope the contributors on SA will share their experiences/comments (kindly) to help those soon to be retired and recent retirees manage cash and effectively make withdrawals from our tax-deferred accounts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.