Smart Spending in Retirement

Congrats! You've retired. Now it's time to ensure you can live comfortably without getting a regular paycheck.

Handling finances as you settle into retirement is surely different than when you were working and earning a steady income. Since most retirees live on a fixed income, making smart money moves in the early part of retirement can help you retain your standard of living in your later years.

Keeping an eye on spending is critical to help make your savings last. Likewise, saving and investing wisely is vital to preserve and grow your nest egg.

This guide will show you how to:

• Design a financial plan
• Set practical spending limits and adjust as needed
• Invest with the proper asset allocation mix
• Create a sound withdrawal strategy
• Minimize your risk of outliving your savings

Being retired means certain work expenses like commuting and wardrobe costs go away. But other costs creep into your household expenses and can mount, such as those involving medical care.

To create a budget, start by tracking the fixed expenses that flow through your checking account over the last 12 months, including monthly utilities and credit card bills, quarterly expenses for services like trash collection or water consumption, and annual or semi-annual expenses for insurance, real estate taxes and the like. Then check your monthly bank statements over the same period for the withdrawal amounts. This will give you a good idea of the cash flow for your household. You might want to categorize your expenses like this.

Scenario A - Sharon has an annual retirement income of $62,000
Sharon receives $12,000 from Social Security, $38,000 from pensions and investments, and $12,000 from working part-time. Her monthly expenses are $2,600. They include $400 for utilities, $500 for car payments and gas, $400 for food and $500 for out-of-pocket health care costs and premiums. She has no mortgage, but has annual property taxes of $3,600. Her non-essentials such as clothing, haircuts, and entertainment are around $500 a month. She is in the 15 percent federal tax bracket and her state taxes are 5 percent. According to Vanguard's online retirement income worksheet, she has about $1,534 a month left over to save.

Scenario B - Frank collects $50,000 in annual retirement income
Frank receives $15,000 from Social Security and $35,000 from investments. His expenses are $3,300 a month. His property taxes and federal and state taxes are the same as Sharon. He has a small surplus of $33 a month, not enough to cover unanticipated expenses or emergencies. He'll need to find a way to cut expenses, bring in extra income or both.

For years, financial planners have researched the most sustainable withdrawal strategies for retirees. Among the most important factors to consider: when to begin withdrawing money and how much retirees can safely take out without jeopardizing depleting their savings. Assuming a 30-year retirement, for a person with $500,000 in portfolio assets, the general rule is to withdrawal no more than 4 percent of that total in the first year of retirement, and then adjust the withdrawal rate for inflation. For example, the first year of retirement you would withdraw $20,000 (or 4 percent from $500,000). The second year, assuming inflation is 2 percent, you would withdraw $20,400. Those with a smaller nest egg would likely reduce that withdrawal rate.

These charts demonstrate the correlation between the withdrawal rate and the likelihood that a retiree will continue to have money left after a 20-year, a 25-year and 30-year retirement, respectively. The charts look at different mixes of a stock and bond portfolio with varying initial withdrawal amounts. In the first simulation, a retiree withdrawing 7 percent annually from a portfolio with a stock/bond mix of 80 percent and 20 percent, respectively, will have a 50 percent success rate of stretching his savings for a 20-year retirement. The success rates increase as withdrawal rates decrease.

Source: Data used with permission from T. Rowe Price

In the following chart, you can see how asset allocation, and the age at which you claim Social Security benefits, also can affect whether your savings will last through retirement. In the Scenario 1 Starting Point, for example, Donald's confidence number, or odds, are pretty good at 83 percent for not outliving his savings based on those factors.

*Used with permission from T. Rowe Price

A study by professors at Trinity University looked at the impact of withdrawal rates on five portfolios over the withdrawal periods of 15, 20, 25 and 30 years, from 1926 to 1995. The portfolios ranged from 100 percent stocks to 100 percent bonds. The withdrawal rates were from 3 percent to 12 percent.

The study found that a 3 percent or 4 percent initial withdrawal rate nearly guaranteed that retirees' savings would stretch throughout their retirement no matter what the payout period or portfolio mix.

Other takeaways from the study:

• People who retire younger should have a lower initial withdrawal rate because they'll presumably have to fund a longer retirement.
• Those who wait longer to retire, and who may have payouts shorter than 15 years, could withdraw up to 8 percent or 9 percent from a stock-dominated portfolio.
• Once withdrawal rates exceeded 5 percent, and payout periods were greater than 15 years, the probability that a retiree's money would last fell significantly.
• A mix of 50-50 stocks and bonds would help most retirees to make their money last.

Although it's impossible to predict the future, when you begin withdrawing your money is as important as how much you take. If the stock market tanks at the beginning of your retirement, causing a big drop in your portfolio, you might have to sell more shares at the time to meet living expenses. Additionally, there will be less money in your portfolio to benefit from a market rebound.

Likewise, if you retire and begin taking withdrawals at the beginning of a long bull market, you're in luck. Profits from a rising market can offset a portion of the withdrawals you take, enabling you to live comfortably while stretching your reserves. In addition, it may be a good idea to find ways to build a regular income stream during your retirement.

Which accounts should retirees tap first for income? That depends. There are taxable accounts, like a savings, money market or brokerage account. Then there are tax-sheltered accounts such as 401(k)s and traditional individual retirement accounts (IRAs). Each of these accounts allows investments to grow tax-deferred until a retiree makes a withdrawal, and then the amount is fully taxable. The same tax treatment goes for annuities, whether they are fixed-rate or variable-rate, if you use pretax money from an IRA or a 401(k) to purchase them. If you use after-tax dollars to buy annuities, then a portion of the payouts will be tax-free.

Roth IRAs are also tax-sheltered (you paid tax on that income when you first contributed to the account) but withdrawals are tax-free after age 59 ½ or until you've held the account for five years. People who are over 70 ½ must take required minimum distributions (RMD) annually from qualified plans like 401(k)s and IRAs; otherwise you will pay a steep 50 percent penalty on the amount you were supposed to withdraw. That's a $5,000 penalty on withdrawal amounts of $10,000, for example.

People are living longer today, thanks to healthier lifestyles and advances in medicine, but this also means more years in retirement to bankroll. According to the Social Security Administration, the average 65-year-old retiree today will live to about 84.3 years for men and 86.6 years for women. Younger generations will presumably live even longer. So retirement income must last 20 or 30 years or more.

Once you decide on the yearly income you'll need to live comfortably, your asset allocation should support that income. Financial advisers recommend having a mix of stocks and bonds for the portfolio to grow after withdrawals, though risk tolerance is an important factor to consider. A portfolio with a higher mix of equities might grow faster but will likely be riskier. Similarly, a portfolio with a larger proportion of bonds will likely grow more slowly without that level of risk.

As retirees grow older, experts recommend that their asset allocation mix gradually become more conservative to support preservation, income, and growth. The idea is that investors become more risk averse as they age because they have less time and ability to make up investment losses. So they choose lower returns from "safer" funds in exchange for less risk. This premise is behind the general rule for asset allocation: You subtract your age from 100 to determine your portfolio's mix of stocks and bonds. For example, if you're age 60, you should have 60 percent in bonds and 40 percent in stocks. At 70, the mix should be 70 percent in bonds and 30 percent in stocks. Some experts argue, however, that this asset allocation model may be too conservative to support longer retirements.

Here is one example of how you might allocate your assets as you grow older, using T. Rowe Price's asset allocation planning tool. Specifically, the bond funds in this example include investment-grade, high-yield, international and all-in-one fixed income funds. The stock funds in this example include domestic large-cap, mid- and small-cap, international and all-in-one equity funds. Investments called cash equivalents in this example include U.S. Treasury bills, bank certificates of deposit, and other short-term, low-risk and liquid products.

• In your mid-60s
  You can afford to have 50 percent in stock funds to accommodate growth, up to 20 percent in cash equivalents, and up to 30 percent in bonds.

• In your mid-70s
  In the second decade of retirement, the focus turns more to fixed income investments and the preservation of capital, although some growth from equities is still recommended. A portfolio might have 15 percent to 30 percent in cash equivalents, 35 percent to 50 percent in bond funds, and 20 percent to 50 percent in stocks.

• In your mid-80s
  The mix of investments grow more conservative as a retiree becomes more concerned with capital preservation rather than growth. Asset allocation could look like this: 30 percent in cash equivalents, 50 percent in bonds, and up to 20 percent in equities.

• In your mid-90s
  At this stage, retirees have likely drawn down some or much of their assets so capital preservation is paramount. Funds that will be needed in the next one to five years should be in safe income-producing investments.

If you have a 401(k), check with your plan administrator about the options available when you exit the job. Some plans allow you to keep your 401(k) with your former employer. Generally, if you have $5,000 or less in that plan, your employer can require you to withdraw funds and close it. If the amount is higher, your employer would need your consent to close the account. Here are some options of what you can do with your 401(k) plan.

• Cash out
  If you close out your 401(k), you'll pay ordinary income taxes in the year in which you took the lump sum payment. That could push you into a higher tax bracket, especially if it is a significant amount of money. You also lose the advantage to grow those assets tax-deferred. If you're under 59 ½, you'll be hit with a 10 percent penalty though there are exceptions. If you retire, quit or are fired at age 55, then you can withdraw funds without penalty from a 401(k), but you'll still pay taxes on that money, according to the IRS.

• Leave it
  If the administrator allows you to keep the plan, you won't be able to add to it, but you can keep or change the asset allocation as you see fit and assets continue to grow tax-deferred until there are withdrawals. Like IRAs, they are subject to required minimum distributions (RMD) at age 70 ½.

• Rollover funds
  This is the option most financial advisers recommend. Roll over the money directly to an IRA to continue the tax deferral until you begin withdrawals and there are no tax implications. If you receive a check, you have 60 days to put it in an IRA; however, some companies will withhold up to 20 percent for taxes. When you open an IRA, you're responsible for coming up with the 20 percent that was withheld to put into the IRA.

• Transfer it
  You can transfer the funds to a variable or fixed annuity. Annuities vary considerably in how they're structured. Generally, a fixed annuity is much like a pension, where you will be guaranteed income if you'd paid for that option. With a variable annuity, you're limited to buying the funds that are in the annuity. The fees on annuities are more expensive than IRAs or 401(k)s because you're buying life insurance and there is a death benefit, too. Like IRAs and 401(k)s, annuities are subject to RMDs.

Pension plans, also known as defined benefit plans, provide a specific and guaranteed retirement income. These are usually calculated by how long a person worked for a company (or in government), the average of the last few years of the person's salary and a percentage multiplier.

Pensioners have several options to choose to collect a benefit. Here are a few of the most common.

• Joint and 50 percent
  The pensioner collects a lower payment for life. In exchange, at the pensioner's death, the spouse gets half of that money for the rest of his or her life.
• Joint and 100 percent
  The pensioner collects a lower payment for life, and in turn, upon the pensioner's death, the spouse gets the same amount of money for the rest of his or her life.
• 10-year certain and life
  The pensioner collects a slightly lower payment for life. If the pensioner dies within 10 years of retirement, the spouse receives the same amount of money until the 10th anniversary of when the pensioner started to collect money. If death occurs more than 10 years after retirement, there will be no more payments to the spouse. This might be something to consider if the life expectancy of the spouse is in question.
• Life only
  The pensioner collects a higher payment for life but payments end at death. This might be worth considering if you are unmarried or have life insurance for a surviving spouse.
• Lump sum
  Pensioner receives a lump sum at one time of the present cash value of what the plan expects the future payments to be. This might be an alternative if the pension plan is frozen, if the company's viability is suspect or if you believe you can money the money properly to generate a similar income.

This example shows how the different options would play out for someone who is 64, seeking to retire in a year, and has a spouse who is eight years younger. The retiree would receive a monthly pension of $2,000.

Once retirees reach age 70 ½, funds held in 401(k)s, traditional IRAs and annuities are subject to RMDs. Funds held in Roth IRAs are not subject to these mandatory withdrawals. If you're still working, anything in your 401(k) plan at that job can stay until you retire. But if you're retired, taking a distribution is required.

RMDs must be taken no later than April 1 of the year following the year you reach age 70 ½. Here's how they're calculated: The IRS looks at year-end values for accounts for the following year's distribution using a uniform life table. On years when portfolios increase because the markets are higher, you'll need to take out more. In years when markets fall, the RMDs are lower.

401(k)
A tax-deferred retirement plan to help employees save for retirement. Usually sponsored by employers, both employees and employers contribute to the plan, which typically offers a mix of investment types and classes.

Annuity, Fixed Rate
A contract with an insurance company in which the company makes fixed dollar payments to the person receiving the annuity for the term of the contract, often until that person dies.

Annuity, Variable Rate
A contract with an insurance company in which a person makes a lump-sum payment or series of payments and the insurer agrees to make periodic payments to the person either immediately or at some future date.

Asset classes
Securities exhibiting similar characteristics, move similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are stocks, bonds and cash.

Asset allocation
How an investor divides up his or her portfolio between asset classes.

Bond
A debt investment. Investors loan money, usually to a corporation or government that borrows the funds for a certain amount of time at a variable or fixed interest rate.

Investment-grade bonds
Issued by companies or organizations that are most likely to meet payment obligations. These are considered low risk bonds.

High-yield bonds
Bonds with a lower credit rating than investment grade or Treasury bonds and that have a higher risk of default. These pay higher yields to compensate for the higher risk.

International bonds
Bonds issued by non-domestic entities, such as bonds from other countries or companies outside of the U.S.

Treasury bonds
Issued by the U.S. government. Considered a very safe investment.

Defined Benefit/Pension Plan
An employer-sponsored plan that will pay a guaranteed monthly benefit to the employee beginning at and through his or her retirement. The amount is predetermined by a formula based on the employee's earnings history, tenure of service and age.

Distribution
Payments or withdrawals made out of an account.

Equities
Also called stocks, these are the value of shares issued by a company.

U.S. or domestic equities
Shares issued by a U.S. company.

International equities
Shares issued by a company that is outside the U.S.

Individual Retirement Account
A retirement savings account that allows investors to save income on a pre-tax basis. Once money is withdrawn, the funds are generally subject to taxes.

Roth IRA
Another retirement savings account, but generally money enrolled has been taxed already, and any gains made are allowed to be withdrawn tax-free.

Liquid Asset
A financial product that can be converted easily into cash without significantly losing its value.

Required Minimum Distribution
The amount of money the IRS requires retirees to take out of their tax sheltered accounts like 401(k)s and traditional IRAs after age 70 ½.

Risk Tolerance
It represents how much price movement a person is willing to tolerate in a particular asset.

Volatility
Swings in the value or price of an asset.