Turning Savings into Income

Saving for retirement is a long climb; spending in retirement is the descent, and it has its own risks. This chapter covers the basics of turning a portfolio into a paycheck: how much you can withdraw each year, why the order of market returns matters so much at the start, how flexible spending makes a plan sturdier, and a general order for drawing from different accounts. The more detailed strategies belong to Volume 2 of this shelf.

How much can you withdraw?

The starting point is the same withdrawal rate used to set the target in chapter 3, now seen from the other side. You withdraw a percentage of the portfolio in the first year, then raise that amount each year with inflation, regardless of how markets do.

With a portfolio of $1,000,000 earning a steady 6.0% a year, with 3.0% inflation, a 4.0% rate means a first-year withdrawal of $40,000. Does it last all 30 years? The engine's answer is yes. At 5.0%, the first withdrawal is $50,000, and the answer is no. Under these steady assumptions, the highest rate that lasts the full period is 4.9%.

The length of retirement matters as much as the rate.

Stretch the same plan to 40 years and the highest steady rate that lasts falls to 4.1%. Someone retiring in their fifties, or a couple where one partner may live into their late nineties, should plan for the longer horizon.

Why the first years matter most

The examples above assume the same return every year. Real returns arrive in a random order, and that order matters a great deal once you are withdrawing. This is sequence of returns risk.

Consider two retirees with the same average return over thirty years. One meets a bad market in the first few years, the other near the end. The first retiree is selling investments at low prices to pay the bills, so the portfolio shrinks and has less left to recover with when markets rise. The second retiree withdrew from a growing portfolio during the good years and can absorb a late fall. Their averages are identical; their outcomes can be very different.

This is why the 4% research tested every historical starting year, not just average returns. Bengen (1994) and the Trinity study (1998) found that the worst outcomes came from retirements that began just before long periods of poor returns, combined with high inflation. The sequence of returns calculator shows the effect directly, and the retirement Monte Carlo simulator tests a plan against thousands of possible orderings rather than one average.

Making a plan sturdier

Retirees manage sequence risk in a few common ways. Each has a cost, and most plans combine more than one.

Spending flexibility. The fixed, inflation-raised withdrawal is the most rigid plan possible. In practice, a retiree who can trim spending by even a modest amount after a bad year, for example by skipping an inflation increase or postponing a large purchase, greatly reduces the chance of running out. Some retirees set guardrails in advance: if the withdrawal rises above a set share of the current portfolio, they cut spending; if it falls well below, they allow a raise.

A cash and bond buffer. Holding one to a few years of spending in cash and short-term bonds means you can avoid selling stocks during a fall and refill the buffer after markets recover. The cost is that cash and bonds usually grow more slowly than stocks over long periods.

A lower starting rate. Starting at 3.5% instead of 4% leaves more margin for a bad sequence, at the price of a larger target or a smaller first-year budget, as chapter 3 showed.

Guaranteed income. Social Security pays an inflation-adjusted income for life, and delaying the claim increases it (chapter 6). Pensions and income annuities can also cover essential spending, so that the portfolio pays only for the flexible part of the budget. Annuities vary widely in cost and terms, so they deserve careful comparison before purchase.

Which account to draw from

Most retirees hold money in three kinds of accounts: taxable brokerage accounts, traditional (pre-tax) accounts, and Roth accounts. The order in which you draw from them affects how much tax you pay over the whole of retirement.

A conventional starting order is:

1. Required minimum distributions, once they begin at 73 or 75, because they must be taken anyway.
2. Taxable accounts, where only the gain on what you sell is taxed, often at lower long-term capital gains rates.
3. Traditional 401(k)s and IRAs, taxed as ordinary income.
4. Roth accounts last, so the tax-free growth continues as long as possible.

That order is a reasonable default, but not always the best one. Drawing only from taxable accounts in the early years can leave large traditional balances that produce big required distributions later, pushing you into higher brackets just when Social Security also starts. Many retirees instead take some money from traditional accounts every year to use up the low tax brackets, or convert part of it to Roth while their income is low. Those strategies, and how Social Security benefits themselves are taxed, are covered in Volume 2. The retirement withdrawal order calculator compares orders with your own balances.

Where to go from here

This volume has covered the foundations: why to start, what you are aiming for, the accounts, the order to fill them, the timeline, and the basics of spending down. Volume 2 on this shelf goes into the strategies built on these foundations: Medicare, health coverage before 65, Social Security claiming for singles and couples, Roth conversions and the backdoor and mega backdoor Roth, retirement plans for the self-employed, health savings accounts, and long-term care. Volume 3 covers retiring early, including how to reach retirement money before 59½. The full library is at /learn.