When the stock market comes under siege, so does the stock portion of your retirement nest egg. A shrinking 401(k) or IRA creates a dilemma for retirees who need to generate income to pay bills: how to take withdrawals in a market downturn and do as little long-term harm to your portfolio as possible.
The greatest threat to your retirement account balance is selling shares when the stock market is falling. The reason: You will need to sell more shares in a down market than in a healthy one to come up with the cash you need. And the more shares you sell today, the fewer shares you will have left to take advantage of the eventual market rebound. “You will compound your losses, and it is hard to recover from that,” says Peter Casciotta, owner of Asset Management & Advisory Services. Your goal, he says, is to take money out without selling at a loss. This is especially true if a lengthy period of losses on Wall Street occurs in the first year or two of retirement when you risk having your portfolio prematurely depleted with a long life span still ahead of you.
Depending on your age, your retirement savings likely will need to last 10, 20 or even 30 years. So you need to look at all your portfolio holdings and map out a withdrawal strategy that helps ensure that you don’t run out of money or won’t have to drastically pare back the lifestyle you envisioned after quitting the nine-to-five grind for good. “You have to be careful about where you are taking money out of,” says Chris Berkel, an investment adviser and president and founder of AXIS Financial. “If you are pulling money from the wrong accounts, the results could be catastrophic to your portfolio.”
So, assuming you have a diversified portfolio (and we hope you do!) with a healthy mix of stocks as well as less-volatile holdings such as bonds and cash, here is a road map — a pecking order of sorts — of what accounts to tap, and why, when the market is volatile.
Employ the bucket approach
It helps if you separate your money into buckets, Casciotta advises. You should have a safe bucket as well as an income bucket and a growth bucket. Rank your holdings ranging from most conservative (think money market or savings accounts) to steady assets (bonds and bond funds) to most volatile (stocks and equity funds). “If you have your buckets set up properly,” Casciotta says, “you should be able to pick and choose assets and not sell at a loss.”
The more options you have to choose from to generate income the better, he says. In general, when stocks are in free fall, you’ll want to first tap cash and bonds, whose values are not directly affected by a stock market correction or bear market.
First, tap your cash
Your first line of defense is to pull from cash accounts, such as your checking and savings accounts, to meet short-term spending needs. By siphoning money from your cash reserves first to supplement your income, you avoid having to sell your stock holdings at a loss and give your portfolio and the stock market more time to recover.
When it comes to cash flow, a steep stock market downturn or a budget crunch caused by inflation can be considered financial emergencies. So there’s nothing wrong with dipping into your emergency fund (which, ideally, should total a minimum of three to six months’ of expenses) to help you make ends meet during a short-lived market downturn, says Mindy Yu, director of investing at Betterment, a digital financial services company. There’s one caveat: If you drain your emergency fund, you risk creating another cash-flow problem down the road when another crisis strikes, Berkel warns.
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Next, focus on fixed income
Your second line of defense is turning to the more stable and defensive parts of your portfolio. That means withdrawing money from bonds and bond funds, which are designed to generate income. They also tend to hold up better and have smaller price swings than stocks do during volatile market stretches.
A caution: The Federal Reserve hiked the key short-term Fed funds rate in March for the first time since 2018 and signaled six more rate increases this year. Rising rates hurt bond prices, so now could be a good time to raise cash by lightening up on bond investments, Berkel says.
Last, sell stocks
You want to hold off selling stocks, or what Casciotta dubs “the dollars you grow by,” for as long as possible. But if you do need to sell stocks, liquidate individual stocks or equity funds that have held up the best in the sell-off, such as balanced funds that hold a mix of stocks and bonds, or growth-and-income funds that own dividend-paying stocks that provide a cushion in market downturns, Casciotta says.
If you need just a little bit of extra income to make ends meet, you might also consider pausing dividend reinvestments in the non-retirement and taxable funds you own and tell the fund company to cut you a check instead, he adds. If you have any huge, outsize winners that have had strong price appreciation, consider selling them to raise cash, as you’ll need to sell fewer shares to raise the money you need. But don’t forget to take tax consequences into account before selling, as capital gains taxes can eat into your profits. Put in a call to your accountant to get a clearer picture of how any asset sales will affect your tax bill.
Don’t forget taxes
Since retirement accounts, such as 401(k)s and IRAs, grow while shielding your gains from taxes, it probably makes more sense to lighten up on stock holdings held in taxable accounts first, especially if you’re in one of the lower tax brackets and the proceeds of a stock sale won’t bump you up into a higher bracket, Casciotta says. If your taxable income is $41,675 or less as an individual, or $83,350 if you’re married and filing jointly, the tax on stocks and stock funds held more than a year is zero.
Taxable accounts typically tend to be more stable and hold more conservative assets than your retirement account, making them less volatile than retirement accounts with bigger weightings of stock. Plus, Uncle Sam allows you to offset $3,000 of capital gains with stock-related losses, Yu adds. If you have additional losses, you can deduct $3,000 from your income and carry forward any other losses to the next tax year.
The last bucket to withdraw from will be so-called qualified accounts, which include 401(k)s and IRAs. Again, the goal is to liquidate as few of your stock shares as you can to fund a lengthy retirement. That’s because history shows that the stock market doesn’t stay down forever. “If you have a longer time horizon, you have time for the market to come back,” Berkel says. Bear in mind that the average life expectancy for men at age 65 is 18.2 years. For 65-year-old women, the average life expectancy is 20.8 years.
However, if a withdrawal from your 401(k) can’t be avoided, Casciotta recommends pulling from your most conservative funds first, as they are likely down less than more risky, aggressive stock funds. That means raising cash for income by selling shares of a balanced fund that holds stocks and bonds or trimming exposure in a so-called lifecycle fund that holds fewer stocks as you age.
Withdrawals from Roth IRAs and Roth 401(k)s — accounts funded with post-tax dollars — are tax-free, of course. So that’s a less costly way to generate income than selling shares and taking distributions from a traditional 401(k) or IRA, which are taxed by the IRS as ordinary income. And if you’re 72 or older and must take required minimum distributions, or RMDs, it makes more sense to pull from your traditional IRA first, as Roth IRAs are not subject to RMDs and it’s better to let those Roth funds continue to grow.
A good way to minimize the amount of selling you need to do in your retirement account is to rein in your lifestyle and curb your spending until the stock market recovers. “Scale back,” Berkel says. One way to do that is to fund only your needs rather than your wants during challenging markets.
Your goal in tough times? “Try to stay the course,” says Betterment’s Yu. “We don’t want anyone to realize any losses due to short-term volatility.”
Adam Shell is a freelance journalist whose career spans work as a financial market reporter at USA Today and Investor’s Business Daily and an associate editor and writer at Kiplinger’s Personal Finance magazine.