Drill Down: How Much Should You Take out of Your 401k?
What does this mean in real life? Do you want to withdraw the minimum or something more than the minimum?
Let’s look at an idealized picture of your retirement account. You start saving when you are young, build up your account balance throughout your working years, and finally pull money out for your retirement. If you plan everything correctly, there’s just enough money left when you die to cover your funeral bills. Your 401k balance will look something like this.
By the way, if that looks like a lot of money, that’s because it is. But it’s a reasonable assumption. The worker behind this account—let’s call him Joe—is an average person, who made an average salary of $38,000 a year. He earned less when he was younger, and more when he was older. At age 65, Joe was making $65,000 in earnings. His first year distribution from his 401k was more than the minimum: it was just over $50,000. Social Security would probably provide around $21,000 to $24,000 a year, so Joe is better off in retirement than when he was working.
If that sounds too good to be true, that’s because it is. Joe could live longer than his official life expectancy. He really should budget as if he may live to be over 100. In fact, I prefer to plan to live to be 105 years old. If Joe follows my advice, he cannot take $50,000 a year out of his 401k; he can only withdraw $26,000 during his first year.
There is a bit of good news, though. My withdrawal plan increases the amount for inflation, so that Joe won’t have a problem with lack of purchasing power as the years go by.
How well will Joe live in retirement? Some of his Social Security earnings will be taxed. (The details are complicated by the amount of Social Security benefits that are taxed ranges from zero to 85 percent, depending on your circumstances.) After taxes, Joe will have about 83 percent of his former salary to live on. Many retirement planning experts believe that’s enough because most people have lower expenses when retired. Also, the hit to Joe’s standard of living isn’t as great because Joe wasn’t living on all of his salary; he was investing nearly $4,000 a year into his 401k.
Wait, though. This little exercise assumed that Joe’s investment returns were about average. For the time period when Joe was working, I assumed that his total return averaged eight percent a year, a reasonably conservative estimate. I further assumed that he shifted his asset allocation more into bonds and money market funds, earning only five percent per year. I think that’s fairly conservative, but it may not be conservative enough. It’s possible that while Joe still had a good portion of his investments in stocks, the market tanked. It’s possible that the bond market went down because of rising inflation. We can’t be sure what his investment returns will be.
Monte Carlo Solution
Researchers have pondered this problem, and found an answer based on “Monte Carlo simulations.” Monte Carlo is that city famous for its casinos. In a Monte Carlo simulation, a computer pulls numbers out that reflect likely returns on investments. The computer is taught the average return, and how often returns are above and below average, and by how much. The resulting answer is often called a “Probability of Ruin, ” the probability that you will outlive your money.
Withdrawals are assumed to increase with inflation, and investments are assumed to be balanced between stocks and bonds. Simulations show that if you pull five percent of your money out of your 401k starting at age 65, you’ll have enough to live on about 75 to 80 percent of the time. The rest of the cases you’d be surviving strictly on social security, scouring the stores for discount dog food to enjoy as your daily meal.
To get that probability of ruin down to just one or two percent, you’ll need to withdraw only three or four percent of your 401k balance.
Bill’s Withdrawal Recommendation: Plan on withdrawing only three percent of all your retirement savings. Once you start, bump up the amount you take out every year for inflation.
What if you only withdrew the required minimum? In this case, you could be confident that your money will last your entire lifetime, even if you reach your 105th birthday. This method, however, has problems as well. Withdrawing the minimum isn’t a good guide because your account balance will be declining when you are in your 90’s. As a result, your required minimum distribution will also be declining. You’d like your distribution to go UP with inflation, not down. As an alternative, you might try taking the minimum until that stops going up by at least inflation; when you reach that point, increase your withdrawal every year by the rate of inflation. With reasonable investment returns, that will take you past 100, but not to 105 years old.
Bill Says: To have an adequate cushion to live a long time or have bad luck with your investments, you need some investments beyond your 401k.
What if you planned your withdrawal rate based upon how much you need? The preceding approach started with how much money you have in your 401k plan and telling you how much you can take out. Coming at the problem the other way would be to figure out how much you need. You might estimate your expenses after retirement, which many financial planners assume is about 70 percent of what you earned when you were working. Joe, who retired at a salary of $65,000 a year, needs $45,500 a year. Social Security will give him about half of that, so he only needs $20,000 to $25,000 a year.
My problem with the needs approach is what happens if your need does not match your investments. Needing a certain amount a year, and then running out of money when you are still alive, is not a very pleasant thought. The bottom line is you cannot afford to take out much more than three percent of your retirement money when you are just starting your retirement.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
» Lesson 7: Your Retirement
Lesson 9: Your 401k, Your Other Assets, and Your Life
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