The consequences of getting the calculation wrong can be quite dire. Take too much, and you may run out of money long before you die. Take too little, and you have been able to do less with your life than you may have wished.
Conventional wisdom suggests the 4% rule, which was initially developed in the 1990s by a California financial planner. According to his research, and subsequent refining by other researchers, an initial withdrawal of 4% of the portfolio balance, followed by an additional 4% every year (and allowing increases for inflation), and a retiree should be good for at least 30 years.
I’ve seen many articles about the 4% rule, but I’ve never seen anyone actually discuss the elephant in the room – the federal government’s Required Minimum Distribution. If your retirement savings are in a traditional IRA or a 401(k), as is quite likely, you don’t actually have a choice in the matter of how little you can withdraw each year.
If your money is in a tax-deferred account, the government wants its share of taxes that it hasn’t yet collected. So you must withdraw at least a specific amount every year, and that amount grows over time. Uncle Sam wants you to withdraw all of your savings, and pay taxes on it, before you die.
Hypothetical retirement portfolios
I ran the numbers on two hypothetical retirees, age 70, and their portfolios, each one beginning with $1 million and running under the following assumptions: the account increases in value by 5% every year, and the withdrawal is taken on December 31 every year.
| 4% | RMD | ||||
|---|---|---|---|---|---|
| Age 70 | |||||
| Balance | $ 1,000,000 | $ 1,000,000 | |||
| Annual Withdrawal | $ 40,000 | $ 36,500 | |||
| Age 80 | |||||
| Balance | $ 1,100,000 | $ 1,070,000 | |||
| Annual Withdrawal | $ 44,000 | $ 57,000 | |||
| Age 90 | |||||
| Balance | $ 1,200,000 | $ 900,000 | |||
| Annual Withdrawal | $ 49,000 | $ 80,000 | |||
The RMD portfolio withdrawals keep going up as a percentage of the balance, so that the annual withdrawal exceeds 10% of the balance by the age of 92. The great news, however, is that even at these accelerated withdrawal rates, the hypothetical RMD millionaire still has almost $500,000 by the time he turns 100.
Now, the RMD retiree must withdraw that amount every year, and pay the commensurate tax on that money to the federal government. Since the withdrawal is a higher amount, the tax due is also higher, and that will eat into the actual net amount that he receives.
Assume, however, that the RMD retiree, like the 4% retiree, can comfortably live on the 4% plus any combination of private pension and Social Security payments that he may receive. What is he to do with the “extra” money, considering that he doesn’t want to spend it all?
What to do with the “Extra” money?
I’m making the assumption that the RMD retiree actually has some “extra money” after paying taxes and deducting the amount that he requires for living expenses. Other papers published recently have questioned the 4% rule, wondering if it is actually too aggressive based on today’s stock market scenarios.
This in my opinion just underscores the fact that, when a retiree is forced to make minimum annual withdrawals that greatly exceed 4% of his balance, he is in danger of outliving his money if he does not continue to invest for both income and growth.
Unfortunately, you can’t just put the extra money back, nor can you put it into another traditional IRA. And unless you have earned income, you can’t put it into a Roth IRA, either.
