1. Determine your desired annual lifestyle spending amount
First and foremost, have a monthly budget. In a perfect world, you would have already tested out this budget over the last year or two, but you don’t always get this opportunity. Regardless, you have this portfolio, and now you need to generate an income stream from it.
To figure out how much you need to pull from your portfolio, first subtract all guaranteed incomes sources coming in like social security or a pension from your total expenditures. Then take away what is required out of your IRA through your required minimum distribution (RMD) for the year (if you are under the age of 70.5 skip this step for now). Then take out any other monthly/annual income you receive from sources such as farm or rental properties. What is left needs to be withdrawn every month/year from your portfolio.
2. Be mindful of taxes
Everything we talk about below comes back to taxes. The less you pay in tax, the better odds you have of not running out of money.
3. Take your RMD at the start of the year
If you are currently taking your RMD at the end of the year and taking your monthly distributions for living expenses from your taxable or Roth accounts you may be paying more tax than you need to be. Take your RMDs out at the start of the year to pay for living expenses. Once this cash is gone, look to pull from your other accounts. Depending on your charitable inclinations and tax bracket, it may make sense to gift your IRA distribution directly to a charity through a Qualified Charitable Distribution or QCD. I will discuss this in more depth in a future blog post.
4. Short term capital gains are evil. Try to only recognize long term capital gains
A few things to think about here:
• Only use tax-managed or tax-aware funds in your taxable accounts. This sounds obvious, but for many it is not. These funds hardly ever distribute short term capital gains. ETFs are another good bet, as you have more control over when capital gains are recognized.
• Focus on buying and holding assets that accumulate unrealized gains. At your death, these assets will receive a step-up in basis. This means that your heirs will not have to pay tax on the sale, as the basis will be stepped up to current market value at date of death. Say you bought Apple stock in 1997 and it is now up 27,000%. If you hold the stock until your passing (assuming you do not need it for cash flow), your heirs can sell it without paying tax on any of the gains.
5. Have an Investment Policy Statement
Most people just have a collection of investments and no real investment plan. An Investment Policy Statement (IPS) is a written investment plan that outlines your allocation to stocks, bonds, and real estate. It provides target holdings within each asset class, and sets rebalancing parameters. It lays out in plain English how the portfolio will be managed, and outlines the risk & return characteristics that have historically impacted this portfolio (worst annual return, maximum 12-month drawdown, growth of $1, etc.) This helps take some of the emotion out of investing, as it is something you can refer back to during the inevitable ups and downs of the market. Just like putting your goals, fitness plan, or diet plan down in writing increases the likelihood you accomplish them, putting your investment plan in writing does the same. You learn that you are supposed to buy low and sell high, but most people do the opposite. They buy high and sell low, and repeat this process until they’re broke. An IPS should help in this regard.
6. Strategically spend from taxable and Roth accounts
You have already incorporated the income streams into your monthly budget that you more or less have little control over (RMD, pension, social security, rent). Now the remainder needs to come from your taxable, Roth, or tax-deferred accounts. The idea here is to limit the tax bite that may present itself. Two things:
1. Be conscientious of the tax bracket you are in.
7. Incorporate asset location
This simply means placing assets in the right accounts. Stocks can be sold at lower capital gains rates, and hence should primarily be held within your taxable accounts. This also allows for opportunities to tax loss harvest throughout the year, which will lower your overall tax bill. Bonds and REITs put off ordinary income (which can be taxed as high as 43.8%), and should primarily be held in tax-sheltered accounts like IRAs. There are always exceptions to these rules, but that is the general rule of thumb that I abide by.
In summary, having a plan to spend down your nest egg is crucial, and cannot be executed haphazardly. Get a plan in place, and don’t just hope and pray that ‘your investment guy’ knows what to do.
Thank you for reading!
Alex Perkins, CFP®