A six-figure 401(k) may not be quite as large as you think it is once it’s time to actually withdraw your money and spend it in retirement.
That’s because nest eggs can lose value over time due to inflation, and withdrawals from traditional accounts are subject to taxes. You may also end up with unexpected expenses such as health care and home repairs in retirement. Those factors affect how much money you actually take home when you want to tap into your retirement savings account, and it can result in meaningful changes to your lifestyle.
Why the balance is not the paycheck
The money you have stored in a traditional 401(k) represents your pre-tax savings. Any withdrawals will be taxed as ordinary income, which can potentially push you into a higher tax bracket. A higher ordinary income can also make more of your Social Security benefits taxable. You can also end up with higher Medicare income-related monthly adjustment amount (IRMAA) surcharges if you withdraw too much in the same year.
You don’t have to worry about taxes on withdrawals from a Roth 401(k). Those accounts are funded with after-tax dollars and qualified withdrawals are tax-free.
The withdrawal math can be sobering
The 4% withdrawal rule is one of the most common rules of thumb for retirees who are ready to live off their portfolios. This rule stipulates that you withdraw 4% of your portfolio the first year of retirement and then adjust for inflation in future years. It’s designed to protect people from longevity risk so they do not outlive their portfolios.
Social Security, cash savings, a brokerage account and other income-producing assets can make the 401(k) math more manageable. Even if your 401(k) withdrawal falls short of living expenses, those other income sources can prop you up. Some retirees also find part-time work to keep busy and pay some of the bills.
How to estimate your real retirement income
Guaranteed income sources like Social Security and pensions can make it easier to keep up with expenses, and it’s important to assess all of those numbers before walking away from your career. If your monthly expenses are $5,000, and you only earn $3,000 per month in Social Security and pension income, you need an extra $2,000 per month to cover the gap.
You can calculate how large your 401(k) balance would need to be to comfortably use the 4% rule to help cover costs. It’s also a good idea to give yourself some padding to account for taxes, inflation and surprise expenses.
You will get the best perspective if you review tax brackets and see how much you will have to pay the government. A gross monthly income of $5,000 per month is not enough to cover $5,000 in monthly expenses since taxes will reduce your earnings. Financial advisors typically recommend reviewing your plan regularly, such as once a year, to ensure you are moving toward long-term financial goals. Knowing how much you can safely spend each month and what your costs will entail can help you make smarter decisions as you plan for retirement.
