Spending from a Portfolio in Retirement

I was recently asked to share my thoughts on how to spend from a portfolio in retirement. In my view (without getting into the topic of whether part of the portfolio should be annuitized) there are three broad questions you have to answer:

1. Which account(s) to spend from each year (i.e., Roth, tax-deferred, taxable),
2. Which assets to spend from (i.e., stocks first, bonds first, or both at the same time), and
3. How much to spend per year.

Which Account(s) to Spend From?

While tax planning is very case-by-case, there is broad consensus on the strategy that most often makes sense. (See this paper or this article from Colleen Jaconetti and Maria Bruno of Vanguard, or my book Can I Retire, for a more thorough discussion of this topic.)

Most often, the overall strategy is to spend in the following order:

1. Spend RMDs,
2. Spend from taxable accounts,
3. Spend from Roth accounts if your current marginal tax rate exceeds the marginal tax rate you expect to face in the future, or spend from tax-deferred accounts if your current marginal tax rate is lower than the marginal tax rate you expect to face in the future.

Of note, #3 isn’t just about tax brackets. It’s about marginal tax rates, which include the effect of various tax breaks phasing out over specific income levels or various taxes kicking in at specific income levels. Also, it’s a dollar-by-dollar decision. For example, in a given year it may make sense to spend from tax-deferred up to a certain point, then switch to Roth spending once, for example, you reach the point where additional income would be taxed at a higher rate (e.g., because you’ve hit the top of your tax bracket).

A tax professional can be very helpful here. Alternatively, if you’re doing the analysis yourself, software such as TurboTax can be useful for running “what if” scenarios (e.g., how much would my overall tax bill go up if I took out an additional $1,000 from my traditional IRA this year?).

Which Assets to Spend From?

With regard to which assets to spend from first, there’s still ongoing debate on the topic.

Most target-date fund providers assume that stock allocation should decline in early retirement, then stay level for the rest of retirement (i.e., spend first from stocks, then spend from both stocks and bonds).

But Michael Kitces and Wade Pfau made an interesting case a few years back that retirees’ stock allocation should actually be lowest in the years immediately before and after retiring, when their finances are most exposed to years of bad returns. That is, your bond allocation should be at its highest point when you retire, and you should be reducing your allocation to bonds gradually from there.

How Much to Spend Each Year?

As far as how much to spend per year, that’s also a topic where there’s a lot of discussion/debate. It mostly centers around whether or not the “4% rule” — in which you spend 4% of your portfolio in the first year of retirement, then increase that level of spending each year in keeping with inflation, regardless of how your portfolio performs — is actually safe.

For instance, Wade Pfau took a look at how a 4% inflation-adjusted withdrawal rate would have worked if used in other countries, and the answer is that it would have been quite risky. That is, it may just be a historical fluke that such a strategy happened to be pretty safe in the U.S. in the 20th century.

In addition, the low interest rates we face today strongly suggest that a 4% withdrawal rate is riskier today than it would have been in the past (in the U.S.), because we can be pretty confident that the bond portion of the portfolio will provide less total return than in most historical cases in the U.S.

A counterpoint, however, is that if you are flexible with how much you spend (i.e., you could easily cut spending if your portfolio experiences poor returns early in retirement), you can start with a higher withdrawal rate. (For a good discussion of this topic, see the second video in this article in which financial planner Jonathan Guyton explains his applicable research.)