Financial advisors know there is an art and a science to helping clients determine which accounts to tap into first when they retire. There are a number of factors to consider when we advise a client on a withdrawal strategy, and one of the best ways to address this piece of advice is to put pen to paper and map it out.
Once an advisor has this information in hand, it’s often surprising how little money clients may need from their portfolios after they walk away from a regular paycheck.
The Checklist
The cash flow plans we develop require us to ask several questions.
After the client’s recurring paycheck ends, will there be a residual (possibly sizable) bonus paying out this year or next year? Will the client be working part time or consulting?
Another important question to ask is whether the client is really ready to retire or significantly scale back work hours. Once many of my successful clients announce their retirement, the calls from friends, former colleagues, corporate boards or headhunters start to roll in. These people may interpret a client’s “retirement” to mean “She’s now available” rather than “He’s leaving the workforce.” So it’s important to ask clients whether they think they’ll be earning some sort of wage during their early years of “retirement.”
Once that’s answered, we ask whether the clients will have deferred compensation or pensions that start paying out. Perhaps they can’t control the timing of these payouts—their company plan rules often dictate when and in what manner this income is distributed upon retirement.
Another important question to ask is, have they been contributing to an annuity and should they plan to annuitize it for another stable source of income (especially if they don’t have a traditional pension)? Do they have stock options expiring that will need to be exercised? If they use a cashless sale exercise strategy, they’ll receive cash to live off of.
Is the client a business owner getting paid out in installments, perhaps over a two- to 10-year period? Will he or she be staying on in a limited consulting role at the new company and therefore have this cash flow coming in?
Looking at all these factors will help determine the optimal time to elect Social Security. If the clients have other cash inflows for the first several years of retirement, it may be best to defer taking Social Security until age 70. Yet early Social Security is still worth considering if it means less in portfolio withdrawals ($25,000 coming in is better than $25,000 going out).
Once I have complete information about the client’s cash flow from all these assets and income sources, I use them to develop a five- to 10-year cash flow plan.
Next Step
Given all that, you may conclude that the client does not need to take a withdrawal from a portfolio right away. Mapping out a multiyear cash flow plan is one of the best ways to determine this. However, if we assume that clients do need immediate withdrawals, what accounts should they draw from first?
First, you must evaluate the client’s ratio of taxable account assets to tax-deferred and tax-free account assets. If all of his or her assets are in 401(k) or IRA plans, there is not much need for further withdrawal plan analysis. All of his or her portfolio withdrawals will be subject to ordinary income tax (unless there is some basis in the IRA or after-tax money in the 401(k), for example).
If the clients have a mix of assets, start by looking at their ages and tax brackets. Given other cash inflows, if they’ll be in the top 39.6% federal tax bracket, any portfolio withdrawals should come from more tax-favored accounts. These sources can include cash in the bank (which have no taxes on withdrawals) or their taxable brokerage accounts (which are taxed at lower capital gains rates).