There is a lot of information available on how to save and invest for retirement. Investors select an asset allocation and learn what accounts to contribute to. But what about in retirement? We are still invested, but instead of saving, we need to spend some of our savings. How much should we have available for spending? When and how do we determine the best time to free up more cash?
In retirement, Keener Financial Planning recommends that you have cash needed for the next two years of distributions on hand. At the end of the first year, you should revisit and determine if the time is right to replenish cash for that second year.
In retirement, we recommend having cash earmarked for the next two years of spending. Cash can be held in savings, money market, T Bills, or CDs. This cash for two years of spending is on top of your emergency fund. The very first year of retirement spending should be freed up the year before your planned retirement as this covers year two. At retirement, you would have one year of cash available for spending with a goal to free up a second year of cash to hit the two-year goal. Continuing this pattern throughout retirement will ensure that you always have at least a year of cash available.
We set up distributions for monthly expenses and set aside cash for lump sum expenses such as travel, car purchases, or home renovations. Organizing your spending in this way provides you with sufficient cash for monthly spending while staying within the parameters of your plan.
But how do we know if we should be freeing up cash for the second year?
End of Year One
In your financial review, we analyze the following when deciding to free up the second year of spending:
- Do we free up cash?
- What account do we free up cash from?
Do we free up cash? When investment markets are up, we always want to free up the second year of cash. You simply calculate what asset classes are over their target percentages and sell those assets to replenish the cash. We count cash for retirement spending as part of the bond allocation. So selling bonds to free up cash is a lateral asset-allocation move.
When markets are down like now, the decision requires more analysis. With the next year of spending already available, you can afford to not sell while stocks are down to raise cash. However, we must always consider how the possibility of even worse market conditions the following year would impact the plan. We recommend weighing this decision on an individual basis considering the plan’s sensitivity to future potential investment losses and the broad range of potential investment outcomes over the next 12 months.
In what account do we free up cash? Where you access your cash is just as important as having the cash available. The tax implications of where you free up cash can be significant. Pulling from your IRA will result in taxable income, but pulling sooner rather than later may result in a lower lifetime tax obligation. Taking from your taxable account may incur capital gains taxes. Pulling from your Roth is tax-free (assuming age/holding period requirements are met), but those funds would no longer be invested for future tax-free growth. Bottom line: tax planning is individualized; one size does not fit all. Your tax planning is not just for the current year but should span multiple years at a high level. A high-level approach allows you to anticipate going into higher tax brackets and determine what, if any, actions can be taken to soften the tax hit. Proactive tax planning allocates more money to your expenses and less to taxes.
With a financial plan in place, you know what your year-to-year spending can look like. A financial plan helps you know how much money you need for the next two years and determine if, and when, you should free up your next year of spending.