Retiring This Year? What You Should Consider.

So, you've just decided to this is the year you’re going to hang up your cleats and quit the working life.   Congratulations.  That's a huge life changing moment for you and your family.   You've amassed this pile of wealth and now you need to figure out how to spend it down.  The skill set required to spend down your portfolio is a much different skill set than the one you followed to accumulate your wealth (i.e., focused savings, starting early, smart spending).  It's more of an art than a science, as there are many variables that need to be weighed against each other.  If you’re not following these steps, you may be paying more tax than you need to, and therefore, have a higher likelihood of running out of money in retirement:

1. Determine Your Desired Annual Lifestyle Spending Amount

First and foremost, have a monthly budget.  In a perfect world, you would have already tested out this budget over the last year or two, but you don’t always get this opportunity.  Regardless, you have this portfolio, and now you need to generate an income stream from it.   

To figure out how much you need to pull from your portfolio, first subtract all guaranteed incomes sources coming in like social security or a pension from your total expenditures.  Then take away what is required out of your IRA through your required minimum distribution (RMD) for the year (if you are under the age of 73 skip this step for now).  Then take out any other monthly/annual income you receive from other sources such as farm or rental properties.  What is left needs to be withdrawn every month/year from your portfolio.  

2. Be Mindful of Taxes

Everything we talk about below comes back to taxes.   The less you pay in tax, the better odds you have of not running out of money and leaving more to your children or favorite charity.

3. Take Your RMD at the Start of the Year

If you are currently taking your RMD at the end of the year and taking your monthly distributions for living expenses from your taxable or Roth accounts, you may be paying more tax than you need to be.    Take your RMDs out at the start of the year to pay for living expenses.  Once this cash is gone, look to pull from your other accounts.    Depending on your charitable inclinations and tax bracket, it may make sense to gift your IRA distribution directly to a charity through a Qualified Charitable Distribution or QCD.  This is important as you are not picking up this income for tax purposes (and does not impact Medicare IRMAA premiums).   

4. Short Term Capital Gains Are Evil.  Try to Only Recognize Long Term Capital Gains

A few things to think about here:

1. Short term capital gains are taxed at ordinary income rates, which can be as high as 40.8%.  Long term capital gains rates are lower, anywhere between 0% and 23.8% depending on your tax bracket.
2. Only use tax-managed or tax-aware funds in your taxable accounts.  These funds hardly ever distribute short term capital gains.  ETFs are another great option, as you have more control over when capital gains are recognized.
3. Focus on buying and holding assets that accumulate unrealized gains.  At your death, these assets will receive a step-up in basis.  This means that your heirs will not have to pay tax on the sale, as the basis will be stepped up to current market value at date of death.  Say you bought Apple stock in 1997 and it is now up 27,000%.  If you hold the stock until your passing (assuming you do not need it for cash flow), your heirs can sell it without paying tax on any of the gains.   

5. Have an Investment Plan & Policy Statement 

Most people just have a collection of investments and no real investment plan.  An Investment Policy Statement (IPS) is an investment plan that outlines your allocation to stocks, bonds, alternatives, and real estate.  It provides target holdings within each asset class, and sets rebalancing parameters.  It lays out in plain English how the portfolio will be managed, and outlines the risk & return characteristics that have historically impacted this portfolio (worst annual return, maximum 12-month drawdown, growth of $1, etc.)  This helps take some of the emotion out of investing, as it is something you can refer back to during the inevitable ups and downs of the market.  You learn that you are supposed to buy low and sell high, but most people do the opposite.   They buy high and sell low and repeat this process until they’re broke.  An IPS will act as your guiding star.

6.  Strategically Spend from Taxable and Roth Accounts

You have already incorporated the income streams into your monthly budget that you more or less have little control over (RMD, pension, social security, rent).   Now the remainder needs to come from your taxable, Roth, or tax-deferred accounts.  The idea here is to limit the tax bite that may present itself.  Two things:

1. Be conscientious of the current tax bracket you are in, i.e. your marginal tax rate.
2. Focus on selling assets with a high tax basis first. In other words, the asset that will recognize the lowest long-term capital gains should be sold first, as long as you are mindful of the rebalance parameters set forth in your IPS.

7. Incorporate Asset Location

This simply means placing assets in the right accounts.  Stocks can be sold at lower capital gains rates, and hence should primarily be held within your taxable accounts.  This also allows for opportunities to tax loss harvest throughout the year, which will lower your overall tax bill. Bonds, real estate, and alternatives that put off ordinary income (which can be taxed as high as 40.8%), should primarily be held in tax-sheltered accounts like IRAs.  There are always exceptions to these rules, but that is the general rule of thumb to abide by.  

In summary, having a plan to spend down your nest egg the right way is crucial, and cannot be executed haphazardly.  You want an expert to help guide you.  It can save you potentially hundreds of thousands in taxes and prolong your hard-earned portfolio.