Managing Your Cash Flow during Retirement

Personal finance articles about good (and some not so good) ways of building your retirement portfolio are ubiquitous. A number of good strategies are well documented and, taken together, they create a nearly a foolproof roadmap to building that retirement next egg. For examples, see some of my previous articles. Unfortunately, I’ve found few good articles on managing your funds to provide the cash flow you need in retirement. Even worse, some of the best tools that work for you in building your nest egg can begin to work against you in retirement if you are not careful.

So, let’s take a look at some of the problems specific to managing your portfolio and cash flow in retirement and then talk about some of the strategies for safe, tax efficient ways of managing the issues.

First, dollar cost averaging. If you’ve read my previous posts, you know that dollar cost averaging is a very powerful tool when you are accumulating your nest egg over the long term. But in retirement, when you are withdrawing, rather than accumulating, dollar cost averaging is reversed and it can work against you. If you are selling assets to raise a specific amount of cash flow each month or each year, you are effectively selling more when the market is low and less when it is high. So, in retirement, you have to either avoid dollar cost averaging or put in place different strategies to avoid the problems with it.

Second, cash. While you are working you need a relatively small amount of cash. A few months living expenses will be enough to get you through most emergencies without too much damage, and other than that, you want to keep most of your money working harder in more profitable assets, such as stocks and bonds. In retirement, your need for cash from your assets is ongoing, so you will need a larger volume of cash. Generally, I think it makes sense to keep 3-5 years worth of living expenses in cash or short term investments. This larger cash fund helps you avoid the negative effects of dollar cost averaging, allowing you to avoid selling securities when the market is down.

Third, taxes. Generally, when you withdraw money from your 401-k or traditional IRA, the withdrawals are taxed at your normal rate. When you sell assets from your after tax accounts, in most cases taxes will be at reduced capital gains rates. The funds you withdraw from cash accounts will be nearly tax free. Generally, from Roth accounts withdrawals are tax free. Prior to retirement, you aren’t bothered with any of these problems because you are rarely making withdrawals. Hopefully you’ve done some tax planning related to this issue, but in retirement, a strategy for tax efficient withdrawal must be optimized based on your situation and may need to be updated regularly.

Fourth, making it last. This is one area where there is some reliable advice out there. It is pretty clear and well documented that retirement rates of 4-5% are the maximum unless you retire later than most. If you go much above that, you are substantially increasing your chance of outliving your money. I, in fact, like to be even more conservative and keep my withdrawals below 4%.

Other than the withdrawal rate, I am astonished to find little good advice for addressing these problems in personal finance articles, hence this post. Let’s take a look at some strategies for addressing these issues.

To avoid problems with dollar cost averaging, the key is to avoid selling when the market is low. There are a couple of good strategies for doing this, both involving keeping increased cash. One often recommended strategy is to build a “CD Ladder”. This involves setting up CDs so you have a long term (up to 5 years) CD maturing each year. This allows you to have the cash you need available each year, but still get the higher rates which are normal for longer maturities. I believe this is a reasonable strategy, although right now long term CDs have little rate advantage, and short term accounts have reasonable yields of around 2-3% above inflation. For this reason I’m keeping most of my cash in shorter term accounts right now.

One of the problems, though, with the CD ladder is that you still need to have approximately the same cash (plus inflation) each year to replenish the ladder. And if you need to sell assets to replenish when the market is down, you still can have dollar cost averaging working against you.

Another strategy, if you have substantial dividends and interest to fund your spending and feel confident these will continue consistently, you can increase your dependence on this asset.

Another strategy is to sell when the market is high, and buy when it is low, keeping a percentage of the cash to fund your cash flow. Not so easy to do, you may say, and this is true. However, if you use the “Dollar cost averaging on steroids” strategy I wrote about in a previous post, you can put this process on auto pilot. I won’t go into the details of that strategy again, but it can effectively supply cash flow from your tax deferred account if you reduce your expected return by your expected withdrawal rate, thereby raising cash over time while still profiting from the market's volatility with a dollar cost averaging process.

And, that brings us to taxes. This can be a complex subject, and I’ll warn that I am not a tax expert. Yet, I have to develop a strategy for tax efficiency to effectively manage my retirement portfolio and have managed little help from the pros in this area. They can give advice about the tax effects of each asset, but apparently most are not trained to optimize the overall tax efficiency.

So, let me talk about the strategies I use, and open it up for discussion. First of all, I do keep a significant amount (3-5 years cash flow) of cash. This gives me the flexibility to ride out long down markets and to operate my “Dollar cost averaging on steroids” strategy. It also allows me to optimize my tax situation by using the cash to avoid high tax events.

Second, I fund my cash flow, as much as possible from sources on which I have a tax burden regardless of whether I use the funds or reinvest. That means I exercise incentive options (and use the proceeds for my cash flow needs) spread over the time period when they must be exercised (and taxed). It means I take my dividends, interest and capital gains distributions to fund my cash flow, since they are taxable, whether I use them or reinvest. For now, I’m not tapping my tax deferred accounts, since I have adequate funding without it and I don’t want to start the high tax withdrawals. Later, when the options have all expired, or when the other sources run low I will begin making withdrawals from the tax deferred accounts. At some point prior to reaching 72 years old, I will probably begin making withdrawals from the tax deferred accounts when I am in a relatively low tax bracket rather than being forced to take larger minimum withdrawals later. Also, in years when I’m in a relatively low tax bracket I’ll look for opportunities to roll some tax deferred accounts into Roth accounts in small increments that do not pump up my tax rate. This will allow me (and possibly my heirs) to avoid tax on the income completely and to withdraw it as needed to optimize my tax situation.

Finally, I have both company stock and after tax funds in my 401-k. When I need income that will not be taxed, and consequently raise my tax rate, I will withdraw the after tax funds. Also, at some point when I may be within a year or so of needing funds, and before I roll over into an IRA, I will take the stock out of the account and keep it for one year, converting appreciation on the gains to a long term capital gains rate.

So, there’s my strategy. I believe this will do a reasonable job of maintaining tax efficiency in my withdrawals. I know I’ve left out a lot of detail, but hopefully this will get you to a position to more effectively develop your options in the absence of much other concerted advice. Get tax advice to make sure you are not making any serious mistakes, but I think it makes sense for you to develop your strategy and get it reviewed before you plunge in.
As I mentioned, I’m open to other ideas. If you have different strategies that have worked for you, please let me know. With all the boomers getting ready to retire, I think it is time for a more robust body of knowledge in this area, and I’m hoping I can help provide/provoke it.