From Nick: “A topic I would like to see discussed is how to apply savings and tax-deferred savings (IRA, 401(k), etc.) at the time of retirement. Assume you plan to retire at 60, expect to live to 90 and intend to leave no money to heirs. If you estimate you will require $100,000 at age 60 and inflation is 4% how much will you need to carry you through your 30 years if your pot of gold earns 7%? How much must you withdraw from tax deferred accounts once you are retired? Assume no Social Security or pensions.”
Well, there are several questions there and I can give only an incomplete answer, but here are a few points to note:
- You’re assuming your money will earn a real rate of 3% (7% growth minus 4% inflation). My trusty calculator tells me that you’d need to set aside just under $2 million at 60 (or any other age) for it to throw off $100,000 a year for 30 years.
- Needless to say, an awful lot depends on your assumptions. Figuring that, under the shelter of retirement plans, you’ll be able to outstrip inflation by 3% is, I think, sensible. You certainly might do better, but there’s no guarantee you’ll do even that well.
- What will you do at 90, when the money’s all gone? To solve this problem, you can either withdraw less than $100,000 each year to make your money stretch further (lowering it to $80,000 stretches the payout from 30 to 45 years; lowering it to $60,000 would make it eternal, based on your assumptions, because you’d be withdrawing just 3% a year) . . . or you can set aside even more than $2 million . . . or you can assume you’ll outstrip inflation by more than 3% . . . or you can buy an annuity from a life insurance company and let it worry about the possibility you’ll live forever.
- The problem with annuities is that insurance companies assume people who buy them will live long lives — you don’t get a lot of terminal patients buying annuities — and so they don’t pay out as much on your $2 million as you might like; i.e., the life insurer isn’t doing this entirely as a favor. People who really do live unusually long make out fine with annuities; those around average make out only so-so; and those who die young are — for this side of a life insurer’s business — the best possible customers. (At 60, you can easily find annuities that pay more than $100,000 a year for life on $2 million — but will it be an inflation-adjusted $100,000? That’s what we’re talking about here: $100,000 a year in 1997 purchasing power.)
- With a Roth IRA, you could withdraw the money over 30 years (or any other number of years) just as you envision. But with a traditional retirement plan, you are required to withdraw certain minimums each year, based on your age when you begin. If I read the table right, you’d be expected at 60 to base your withdrawal amounts on a 24-year payout schedule. (Longer if married, and there are a couple of ways of figuring this — I’m just trying to give you the flavor of it. The personnel department that administers your 401(k), or the financial institution that administers your IRA or Keogh, probably has a pamphlet with the details.)
- The actual dollar amounts would not be a flat $100,000 a year. To keep up with inflation, given your assumption, you’d withdraw $104,000 the second year — even as your $2 million had not shrunk by $100,000 but (earning 7%) had actually grown by $40,000. By the final year, your withdrawal would be about $325,000 — which, if there’d actually been 4% inflation along the way, would be the equivalent of $100,000 when you started 30 years earlier.
- Assuming you have some savings outside a retirement plan, you will want to use it first, letting your tax-sheltered money grow as long as possible. Knowing this, the IRS imposes a stiff penalty on those who under-withdraw the minimums from their retirement plans. (Again: the exception will be the new Roth IRA, starting January 1, 1998, withdrawals from which will have no minimums.)
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