As a general rule, you should withdraw money from your savings during retirement in the following order:
- Taxable accounts such as joint-tenant accounts, because the money already is “exposed” to income tax and may qualify for preferential capital gain treatment under the right circumstances.
- Tax-deferred retirement accounts such as 401(k)s, 403(b)s, and traditional IRAs, so you can potentially delay paying taxes on this money as long as possible.
- Tax-free retirement accounts such as Roth IRAs, because waiting until the end to withdrawal that money will allow it to grow unhindered by taxes.
Combining Lifetime Income and Withdrawal Strategies
Retirement experts suggest dividing your living expenses into three categories:
- Essential expenses
- Nonessential expenses
- Nonessential lifestyle expenses
Essential expenses: You can pay for essential expenses—such as food, clothing, utilities, and health care—with lifetime income, such as Social Security and/or annuity income. You can increase your lifetime income by working longer, perhaps on a part-time basis, to delay drawing Social Security benefits.
Nonessential expenses: You can pay for nonessential expenses, such as travel and entertainment, with retirement savings, following the withdrawal strategy order mentioned above. This combined approach can give you peace of mind, knowing you will be meeting your basic needs. If you do not have enough lifetime income to meet your essential expenses, you can convert some retirement savings into lifetime income, perhaps by purchasing an immediate annuity.
Nonessential lifestyle expenses: You can spend your remaining retirement savings—taxable first, then tax-deferred, then tax-free—to meet your nonessential lifestyle expenses. A good guideline is to not spend more than 4 percent of your retirement savings on lifestyle expenses in any given year. In good years, when savings generate great returns and essential expenses are covered, you might be able to spend more on nonessential expenses. In bad years, when savings are flat or even down, you may reduce nonessential expenses and withdraw less than 4 percent, knowing that your essential expenses are covered by your lifetime income sources.