June 14, 2010. With volatile markets putting retirees on edge, a question we frequently address is “How much can I take from my IRA?” We like to add an additional ingredient “and still preserve the principal.” IRAs are great planning tools for retired police officers and firefighters: they allow the retiree to have a tax-deferred way to preserve their deferred comp (§457) or annuity withdrawals. There are two normal ways of funding an IRA, either through contributions or by rolling over a distribution from another plan, like deferred comp.
The first question in trying to figure how much you can take out is figuring out how much you must take out of your IRA. Traditional IRAs (including rollovers) have a Required Minimum Distribution (RMD) that is mandated by law. You must begin taking money out of your IRA by April 1 after you reach age 70 ½ or face a 50% penalty on the required distribution. The required distributions are determined by a published IRS Table: you divide your beginning of the year balance by the factor on the table, which is based on a joint life expectancy. As you get older, of course, your life expectancy gets shorter, and the amount you take out increases. In general, the RMD at age 70 ½ is about 4% and gets progressively larger.
The second big question is trying to take inflation into account in your withdrawals. Say you have a $200,000 IRA at the Credit Union, all in CDs. Let’s suppose those CDs make 3% (good luck on that one in today’s market!). You take $6,000, or the interest out every year. So it appears that you are easily preserving the principal. However, every year, because of inflation, your purchasing power is declining. The $6,000 you take out in the first year won’t buy as much as the $6,000 in the fifth year. You might also notice that if you’re making 3% and you are over 70 ½, you have to take out 4% or more, and you will erode the principal.
So you must start distributions at 70 ½, but how much can you take, preserve your purchasing power and preserve principal? We’ve done substantial research on this issue and there is one essential factor to preservation: Real Rate of Return. Real Rate of Return is your rate of return adjusted for inflation. In an oversimplified calculation, Real Rate of Return is your return less the rate of inflation. So, if your IRA is earning 7%, and inflation is 3%, your real rate of return is 4%. If your IRA is all in bank deposits earning 2%, and inflation is 3%, then your real rate of return is -1%. Here’s the basic rule: If you want to preserve purchasing power and capital, you should only withdraw at or less than your real rate of return.
Here are three scenarios of how the Real Rate of Return works. Let’s take three examples: Let’s look at a retiree who is age 64. He has $300,000 in his IRA. He wants to take out a $1,000 monthly distribution, have some fun, and stay out of trouble on the Required Minimum Distributions when he hits 70 ½. He wants to increase the distribution by 3% a year. He’s considering three investment options: CDs at the Credit Union (paying 3%), annuity paying 5%, or a balanced investment that should make about 7.5%. For this example, assume inflation is 3%.
First Scenario: 3% CDs. It should come as no surprise to anyone that if you make 3% and take 4% out, you’ll run out of money. What may come as a surprise is that because of the compounding effect of inflation and interest, the 3% investment is doomed to fail quickly. Our retiree will totally run out of money by age 89. The Real Rate of Return is zero (3%-3%=0), and zero is less than the withdrawal rate (4%), so this one will fail (unless our retiree starts smoking, drinking and riding his Harley without a helmet). The total amount our retiree would have gotten from the 3% IRA is about $456,000
Second Scenario: 5% Annuity. Under this scenario, the rate of return (5%) exceeds the withdrawal rate, so the IRA doesn’t blow up as quickly. However, the simplified Real Rate of Return (5%-3% = 2%) does not exceed the withdrawal (4%), so this one also will fail, but over a longer period of time. By age 95, our retiree would still have about $115,000 of the $300,000 left. By 100, it would be gone. To compare, the total amount received or held by age 89 (when the CD based IRA would be gone) is about $689,000 (Distributions, plus the retiree still has about $227,000 in their IRA). 2% more return gets about $230,000 more to the retiree.
Third Scenario: 7.5% Investment. This scenario uses a balanced portfolio that earns on average 7.5%. Here the Real Rate of Return is about 4.5% (7.5%-3%=4.5%). 4.5% is greater than the withdrawal. This plan will work. By age 89, when the CD IRA would be gone, the 7.5% IRA has a balance of over $475,000. In addition, the distributions at age 89 (because of the RMD rules) are a whopping $63,400 a year. By age 89, when the 3% IRA would have been gone, the 7.5% IRA has generated distributions plus a balance of just under $1.15 million.
So the key to a sustainable withdrawal is enhancing Real Rate of Return. You have to make a real rate of return greater than your withdrawal rate. You have to take into account the fact that you must take distributions at age 70 ½. Over history, many studies (including ours) have shown that the key to having a sustainable withdrawal is not being too conservative. In fact, the most conservative portfolios (like 100% bonds) had consistently the highest failure ratios. Similarly, being too aggressive (like all equities) also causes prospective failure when the market does a big drop. The portfolio in historical studies that provided the highest success and highest consistent real rate of return is about 60% equities and 40% bonds. Of course, this presumes you’re not paying a bunch of fees and loads to get your investments, and that you stay invested and keep the mix stable at that 60/40 blend. We frequently modify that blend to 50% equities and 50% bonds which still has a good real rate of return and lets our retirees sleep well at night.
Bottom Line: Invest your IRA like a pension plan. Pensions are designed to provide a sustainable withdrawal for the retirees. It should be no surprise that the average large pension plan has an asset mix of 60% equities and 40% bonds.
Leon C. LaBrecque JD, CPA, CFP® CFA and Matthew Teetor are advisors at the independent advisor firm of LJPR, LLC. Matthew and Leon run the firm’s practice for public safety officers. LJPR reduces uncertainly in the lives of Michigan police officers and firefighters by applying creative wealth management solutions in tax, financial planning, retirement planning and estate planning. To contact us for a consultation or to discuss group programs for your unit, contact firstname.lastname@example.org or call 248-641-7400. Also visit our website http://LJPR.com.