Advisors Tackle Decumulation as Americans Boom Into Retirement

With more Americans hitting retirement than ever before, savvy financial advisors are focusing on the crucial withdrawal stages of investment management.

After decades of working, saving and investing to afford a comfortable retirement, the challenge ahead for many of the more than 4 million Americans turning 65 annually is how best to start making withdrawals that factor in taxes, longevity and legacy. One of the most important aspects of decumulation is sequence-of-return risk, which relates to the timing of investment gains and losses in relation to the overall investment portfolio, particularly during the withdrawal phases. Unlike average returns, which measure overall growth, sequence-of-return risk focuses on the order in which returns occur. For example, negative returns early in the withdrawal stage can have a disproportionately large impact on a portfolio because withdrawals during a downturn reduce the amount of principal available to recover when markets rebound.

“The No. 1 thing to think about is the sequence-of-return risks, and that’s the risk that is the least understood and the least discussed,” said Chuck Failla, president of Sovereign Financial Group. He is among financial advisors who address portfolio risk during retirement by separating investments into buckets pegged to distinct time periods from short term to long term. “If the market corrects, that’s not necessarily a problem for your portfolio if it’s constructed properly,” he said. “You could experience corrections and still be OK if they do something to mitigate the sequence-of-return risk.”

It’s on my Bucket List

Bucket strategies can be employed and invested in a variety of ways, but the basic concept involves separating a portfolio with investments dedicated for as short a period as 12 months for living expenses and emergencies all the way out to 10 years and longer, which is where the most aggressive investments are held. Brian Eder, private wealth manager at OnePoint BFG Wealth Partners, describes managing withdrawals during retirement as “more art than science,” but he does rely on a version of a bucket strategy to help clients navigateincome needs and tax planning.

“To take withdrawals in retirement correctly creates more enjoyable utility versus someone who isn’t maximizing the opportunity,” he said, adding that there are many factors to consider when taking withdrawals, including how the withdrawals  impact current-year tax planning as well as Medicare premiums the following year. It’s also important to consider the timing of the withdrawal from a market perspective and have a clear understanding of your clients’ cash flow needs.

Eder’s bucket strategy involves investing capital based on estimated needs. “If we know that a client wants a certain amount of money for the next three years, we think that capital should be interest-bearing and not market-invested,” he said. “Money over the course of three to 10 years can be treated differently with a different allocation between cash, stocks and bonds.”

Money allocated for use more than 10 years out, Eder said, is treated similarly to capital that’s more “generational” and likely won’t need to be spent. “It can be confusing and overwhelming, but well-prepared clients should have a five-year pro forma for income planning that lays out how and where cash will come from and the estimated tax impact,” he said. “Beyond five years also matters, but more macro than detailed.”

Retirement Dreams, Tax Realities 

Alongside the bucket strategy that helps clients avoid the psychological roller coaster of imagining how market movements will impact their lifestyle, managing the withdrawal stage also puts a fresh focus on tax management. “Helping navigate the tax code is a big part of what we do, and if we can help keep Uncle Sam out of your back pocket, that’s more you get to keep in retirement,” said Ryan Ledden, president of Black Oak Asset Management. “Taxes are one of the biggest factors that you have to consider in retirement as you withdraw your funds.”

With many clients holding investments in a blend of taxable accounts, tax-deferred accounts, such as a traditional IRA, and tax-free accounts, such as a Roth IRA, advisors are focused on where to withdraw money from and what kinds of investments are best suited for each account type. “Knowing where to take money from and when to retire is very important, but it starts with having the right investments in the right accounts,” Ledden said. “I have read many articles that say you should take from certain accounts until they go to zero and then start with the next type of account; this is the puzzle I love to help our clients put together.”

Ledden said there are no easy answers because much of the withdrawal and tax management strategy depends on each client’s income sources and tax bracket.

“We look at their nest egg and the accounts they have to determine where additional income should be pulled from, mostly based on taxes,” he said. “We have to pay our fair share of taxes, but let’s navigate the tax code laid out before us.”

Cut from the Same Roth

Kimberly Foss, senior wealth advisor at Mercer Advisor, cites the tax-free benefits of the Roth IRA for adding a few more wrinkles to the tax management side of retirement withdrawals. “With Roth accounts, retirees have the option of tax-free growth and non-taxable withdrawals,” she said. “This is making Roth conversions appealing to some approaching retirement, especially those who think that required minimum distributions, along with other retirement income and fewer deductions available, might throw them into a higher tax bracket in retirement.”

The Roth IRA, established nearly 30 years ago as part of the Taxpayer Relief Act of 1997, has become a major part of many retirees’ investment portfolios. Foss said conventional wisdom used to believe in leaving tax-favored accounts like traditional IRAs and 401(k)s alone as long as possible so that they could grow tax-free. “We would tap into taxable sources first and then, when those were depleted, start drawing down tax-advantaged retirement accounts,” she said. “However, the advent of Roth accounts has altered that approach somewhat.”

Foss said another approach for stretching out the tax burden is to start withdrawing from traditional IRAs and 401(k)s even before RMDs kick in. “By turning to tax-free income streams later in retirement, including Roths, clients pay less in taxes over the span of their retirements,” she said. “This may also enable them to reduce taxable income in later years, potentially saving more of their Social Security income from taxation.”

Tax Deferred. When it comes to managing taxes, Dave Sharpe, wealth manager at Savvy Advisors, said the general rule is to let tax-deferred money grow as long as possible while spending from taxable accounts first. “But the real answer is more nuanced and depends heavily on your current and projected tax brackets,” he added. “Drawing from a traditional IRA in a low-income year, for example, may be smarter than waiting, especially if it allows you to defer Social Security or reduce future RMDs.”

Roth accounts, Sharpe said, are “best preserved as long as possible since withdrawals are tax free and they carry no RMD requirements during the owner’s lifetime.”