Retirement Withdrawal Strategies

While you might be forced to take a required distribution from some of your accounts when you turn 72 years old, you should still come up with a plan to ensure that your savings can last you for the rest of your life—and empower you to live comfortably. Considering the tax implications and comparing various financial strategies will help you make choices for your withdrawals to ensure you make the best choices.

401(k) Withdrawals

A 401(k) is a tax-advantaged retirement account typically managed by an employer for its employees. You contribute to 401(k) accounts with pre-tax money; contributions are usually deducted directly from your paycheck.

As soon as you turn 59 ½, you can begin to take penalty-free withdrawals from your 401(k). As with an IRA, early withdrawals are possible, but you’ll pay a penalty of 10%.

There are a few exceptions that allow you to take a withdrawal from your 401(k) early and without penalty, including:

• You become disabled
• Certain medical expenses
• Home purchases
• College tuition, as well as some other educational expenses
• To repair damage to your home
• To prevent foreclosure on your home

That said, any money taken from your 401(k) early means it has less time to compound and grow for your retirement. It should always be seen as an absolute last resort.

When to withdraw from your 401(k)

Once you reach 59½, you can take distributions from your 401(k) plan without being subject to the 10% penalty. At this point, any amount you withdraw will be subject to income taxes.

After turning 59 ½, you are not required—at first—to take withdrawals, but eventually, the IRS will force you to do so. Unless you’re under a plan that allows delaying withdrawals while you continue to work, you’ll need to start taking your required minimum distributions (RMDs) at age 73 (if you were born between 1951 and 1959) or 75 if you were born in 1960 or later. 75 is a new age for RMDs; the age was previously 72 before the Secure Act 2.0 was passed in December 2022.

Depending on your company’s rules, you might choose to take regular distributions in the form of an annuity for a fixed period or for the rest of your anticipated lifetime. Alternatively, some companies allow for nonperiodic or lump sum withdrawals.

If you wait to withdraw from your 401(k) until you are required to take your RMDs, you must take regular periodic distributions that are calculated based on your account balance and life expectancy. You can always withdraw more than the RMD calculation, but not less.

If you’ve hit your RMD age and you don’t need the funds imminently, you might be able to reinvest the RMD amount into a Roth IRA, as long as you have earned income in an amount equal to or greater than the RMD amount you contribute to the Roth. That said, note that the RMDs will count as taxable income, plus you’ll pay taxed on Roth IRA contributions. Roth IRA withdrawals are tax-free, however—so if you anticipate being in a higher tax bracket in a few years, this move could be worth it, despite the upfront tax burden.

Ultimately, the choice to take and spend your 401(k) withdrawals or reinvest them is a decision to be made with careful consideration, after weighing your current financial situation and discussing your retirement plans with a Certified Financial Planner (CFP®).

When to start withdrawing: The decision will be up to you, your financial advisor, and your overall withdrawal strategy, but you must start taking RMDs the year after you turn 73 or75, depending on when you were born.

Withdrawal deadlines:

Age 59 ½: Penalty-free withdrawals allowed

Age 73: RMDs begin for those born between 1951 and 1959

Age 75: RMDs begin for those born in 1960 or later

IRA Withdrawals

You can begin withdrawing from your IRA without a penalty after you turn 59 ½. If you withdraw before you turn that age, you will pay a hefty tax penalty to the tune of 10%, unless you can get a special exception.

Special exceptions are made for things such as:

• Permanent disability
• Higher education expenses
• First-time homebuyers (up to $10,000)
• Health insurance premiums while unemployed

When to withdraw from your IRA

You won’t be forced to withdraw money from your IRA until you turn age 72. At that point, required minimum distributions (RMDs) go into effect. The minimum amount you will need to withdraw each year is considered your required minimum distribution, or RMD. You can withdraw more than this amount, but withdrawals from a traditional IRA that exceed it are considered taxable income. Withdrawing less than your RMD will result in a 50% excise tax.

With Roth IRAs, there is no RMD. Contributions are made with after-tax funds, so withdrawals are not taxed.

If you’re financially able to wait until you are forced to take your required minimum distribution, there might not be a reason to take money out of your IRA early. Every year that it is allowed to grow means more money for you to invest for the rest of your retirement.

In addition, just because it’s time for you to take your RMDs, you don’t necessarily need to spend them. You could absolutely re-invest that money if you have other sources of income to sustain you during retirement.

Some people might choose to purchase an annuity with their RMDs, which can turn assets into a stream of income payments. You could also opt to invest in bonds, stocks, mutual funds, or ETFs (exchange-traded funds).

Finally, there is also an option to turn your RMDs into a Roth IRA, though you will need other earned income that allows you to meet the earned income requirement for Roth IRA contributions. You’ll need to pay income taxes on the Roth IRA, but the account will grow tax-free. Roth IRAs do not have RMD rules attached to them, so you can take them out at any time, for whatever amount you wish. Note that with this option, you’ll still need to pay taxes on the RMD and the Roth IRA—it is not a roll over.

When to start withdrawing: The decision will be up to you, your financial advisor, and your overall withdrawal strategy, but you must start taking RMDs the year after you turn 72.

Withdrawal deadlines:

• Withdrawals are allowed after you turn 59 1/2.
• RMDs kick in the April after you turn 72

Common Withdrawal Strategies

Over the years, economists and financial planners have developed some common withdrawal strategies to help everyone maximize their investments and minimize their tax implications. These strategies are also meant to simplify the complicated field of retirement withdrawal planning, but they aren’t one-size-fits-all; many people need to employ a combination of several strategies to develop a plan that works for their retirement.

What is the 4% Withdrawal Rule?

The 4% rule dictates that you withdraw 4% of your savings the first year of retirement, and then readjust the percentage in future years based on inflation. Because the rule was developed many years ago, it doesn’t necessarily take into account periods of very high inflation—like what we have experienced in recent years—or instances where you may want to take out a little more in the first year to travel, while dialing down the withdrawal in subsequent years.

In addition, the rule assumes you have a very specific portfolio composition: 50% in stocks and 50% in bonds. You might change your portfolio composition over the years, and might diversify more than this formula allows.

Finally, the 4% rule assumes a 30-year timeline. Depending on your age and health, 30 years might be too liberal or too conservative, and the percentage you withdraw should best match your life expectancy.

Advantages:

• Simple, easy-to-follow formula
• Offers predictable income
• Protects you from losing money in retirement

Disadvantages:

• Very strict
• Based on poor portfolio performance
• 5% might be a more realistic withdrawal amount, but it can vary based on life expectancy

What are Fixed-Dollar Withdrawals?

The fixed-dollar withdrawal strategy states that you withdraw a fixed amount each year—whatever you need to live—and then reassess that amount every two or three years. That way you can raise the amount if your investments do very well, or lower the amount if the opposite happens.

Here’s how the fixed-dollar withdrawal strategy could look: you might withdraw $40,000 annually, then reassess that amount after a set period, somewhere between two and five years. This offers predictable income, which is helpful for budgeting, but has one of the same failings as the 4% rule—it doesn’t account for inflation.

In addition, depending on the amount you set, you’re at risk for eroding your principal.

Advantages:

• Simple to manage
• Set amount allows for easy budgeting

Disadvantages:

• Exposes you to extreme inflation swings
• In a down market, you might need to liquidate assets to meet your fixed amount

What are Fixed-Percentage Withdrawals?

Instead of adhering to a fixed withdrawal amount, the fixed-percentage withdrawal strategy recommends withdrawing a predetermined percentage of your portfolio on an annual basis. The dollar amount will vary year-to-year, based on the value of your portfolio. There can be uncertainty with this method, as you won’t know the specific income you will have each year, but if you select a percentage below the anticipated rate of return it’s possible that you will grow your income and account value. Too high a percentage, however, and you risk exhausting your assets early.

Here is how this might play out for you: if you have a portfolio of $1,500,000 and decide to withdraw 3%, you’d have $45,000 to spend for the year.

For those on a fixed retirement budget, this rule could be challenging. If you are considering it, it might be best applied to discretionary expenses that allow for more flexibility in the case you need to reduce spending.

Advantages:

• Easy to understand formula
• Choosing a percentage below the rate of return could yield gains

Disadvantages:

• Your income changes from year to year, making it difficult to budget
• Too high a percentage could risk your assets

What is a Withdrawal “buckets” Strategy?

Using the “buckets” strategy, you would withdraw assets from three core buckets—these are three separate types of accounts containing your assets, as follows:

• The first bucket is your cash (and cash equivalent) savings, usually about three-to-five years of living expenses
• The second holds fixed income securities
• The third bucket holds your remaining investments in equities—these should be your riskier holdings

As you use your cash from the first bucket, you then replenish it with earnings from the second and third buckets. The idea is that once you have set aside a set amount of cash to live on, you give your investments more time to grow.

As you develop a bucket strategy, you need to be aware of the “sequence of returns risk.” If your portfolio takes an unexpected, large hit during the first few years of retirement and you tap into it while it is losing value, you’ll need to sell a larger proportion of your investments to raise the needed amount of cash to sustain your income. This can deplete your retirement funds faster than anticipated, and leave you with fewer assets to generate growth when the market recovers.

If there is a big loss during the beginning years of your retirement, you could reduce your withdrawal amount—either by cutting living expenses or cashing in on other assets. You could also forgo inflation adjustments. In short, it’s critical to do what you can to avoid selling investments when the market is in a downturn.

Ideally, with the bucket investment, you have enough of a nest egg to sustain you through years when the market is down. Try to fill your first bucket with at least a year’s worth of cash and three to five years’ worth of expenses in high-quality cash equivalents. This will give you extra padding to help you withstand market volatility.

Advantages:

• Buckets can be somewhat flexible; you can choose a shorter or longer timeline for your cash bucket
• What you keep in buckets two and three is up to you—again, an added layer of flexibility
• Helpful if you have a larger nest egg

Disadvantages:

• Requires projecting your budget three to five years in advance—and sticking to it
• No predetermined suggestion for investing in each bucket, which could be confusing for some
• Some retirees might consider it a conservative withdrawal approach; if you hold too much in your immediate bucket, your long-term growth bucket might not out-earn withdrawals and inflation
• Ignores asset allocation

Any of the above strategies can be mixed and matched to best suit your retirement goals, financial picture, and risk tolerance. Everyone has different expenses and different vision for retirement—pick a withdrawal strategy that supports your budget and lifestyle. Ultimately, the best way to determine which of these strategies is best for you is to speak with a Certified Financial Planner (CFP®).

Frequently Asked Questions

Should I use more than one retirement withdrawal strategy?

Many financial planners believe that a “mix and match” approach to withdrawals is a wise one—usually, this allows you to strategize specifically to match your investments, available cash, and risk tolerance.

What is the most popular retirement withdrawal strategy?

Possibly because it’s been around for so long, the 4% rule is considered the most common withdrawal strategy. It is also frequently used because it is so simple to follow; the formula states that you withdraw 4%, and simply adjust each year for inflation. That said, some financial planners believe the rule is too rigid and outdated to match today’s economy.

Should I take money out of my 401k to pay off debt?

Taking money out of your 401(k) to pay off debt could create a headache of tax bills and penalties, and ultimately push your retirement date far into the future as you’ll be losing on thousands of dollars of compound interest. That said, everyone’s financial picture is different and it might be necessary. Speak with a financial advisor to weigh all your options—they might suggest a debt consolidation loan as an alternate strategy.

How can I avoid the penalty on my 401k?

There are only a handful of reasons you are allowed to withdraw money from your 401(k) early and without penalty.

401(k) hardship withdrawals include:

• Medical bills
• Disability
• Health insurance premiums
• IRS payments
• First-time homebuyers
• Tuition and some qualified education expenses

When Do I Have to Start Making Withdrawals From My IRA?

Generally speaking, you can start to use your IRA to fund retirement, but you will be required to take funds out starting at age 72. Roth IRAs do not require withdrawals until the account holder dies.

When Can I Start Withdrawing Money From My 401(k)?

As soon as you turn 59 ½, you can begin to take penalty-free withdrawals from your 401(k). As with an IRA, early withdrawals are possible, but you’ll pay a penalty of 10%.

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