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A smart way to make your retirement money last

Let's say you're fortunate enough to have saved $500,000 for retirement savings. What's the best way to use those funds? Let's take a look at one smart strategy that includes recommended approaches for taking Social Security benefits and working in retirement, as well as an insurance innovation that has gained support from recent regulations.

We'll use the example of a single, healthy, 65-year-old woman who's making a salary of about $75,000 per year ($6,250 per month) before retirement.

Her first step should be to delay taking Social Security benefits until age 70 to maximize the value of that key benefit. If she starts taking Social Security right away at age 65, her monthly income will be $2,000. If she waits until age 70, however, her monthly benefit will be about $2,828.

The best way to enable delaying Social Security is to work part-time until age 70, and then try living on two-thirds of her salary, which turns out to be $50,000 per year.

The reason? When she eventually retires completely, she'll aim to receive a total retirement income of that amount. Getting used to living on that amount is called "practice retirement," a concept developed by T. Rowe Price. One way she'll be able to do that is to stop saving for retirement during this time.

Suppose she works half-time from age 65 to 70, which gives her enough free time to feel like she's retired. If she can work at the same pay rate she got when working full-time, she'd earn about $37,500 per year. She could then withdraw $12,500 per year from her savings to bring her total income up to the $50,000 annual target income.

If she withdrew this amount for five years until age 70, it would add up to $62,500, which she should set aside now in a liquid investment account in her 401(k) plan.

The next step of her strategy is to take advantage of recently issued regulations on qualifying longevity annuity contracts (QLACs) to insure against the possibility of running out of money should she live a long time. She'll devote $75,000 to a QLAC that will generate income beginning at age 85, with no death benefit if she dies before that age (this is the least expensive form of this annuity).

According to a recent quote from Income Solutions, a woman age 65 with $75,000 in savings can buy a monthly income of about $3,190, beginning at age 85.

After buying the QLAC and setting aside the $62,500, she'll still have $362,500 in retirement savings. She would invest this amount until she retires full-time at age 70, when she'll start using it to generate retirement income.

Let's assume this savings grows to $450,000 by age 70, which could happen if she earns a little less than 5 percent per year from age 65 to age 70.

At that point, she'll use the required minimum distribution (RMD) rules to determine the amount of her retirement income. She could invest in a low-cost target-date mutual fund that invests in a mix of stocks and bonds and shifts assets over time from stocks to bonds to reduce exposure to volatile stocks.

The RMD rules recalculate her annual withdrawal amount at the beginning of each calendar year by dividing the amount of her account balance at that time by her remaining life expectancy (using mortality tables in the IRS regulations). She isn't required to begin withdrawals until age 70-1/2. At that age, the RMD rules result in an annual income of 3.65 percent of her account balance. To keep this example simple, let's assume she starts her retirement income at age 70, not age 70-1/2.

Applying the 3.65 percentage to the $450,000 results in an annual retirement income of $16,425 in her first year of retirement, or about $1,369 per month. Adding her Social Security income of $2,828 per month results in a total monthly retirement income of $4,197, which is roughly two-thirds of her pre-retirement pay. (Actually, the $2,828 Social Security benefit will rise with cost-of-living increases, but let's ignore that for now for simplicity's sake).

Under the RMD rules, the withdrawal percentage increases each year. For example, at age 71, she'd need to withdraw 3.77 percent of her remaining account balance instead of 3.65 percent. Most IRA and 401(k) administrators will calculate the RMD amount each year for her, so she doesn't need to be an actuary.

Using the RMD rules, her retirement savings should last for the rest of her life because she'll readjust her income amount each year, recognizing any investment gains or losses during the year. However, if she incurs significant investment losses, her income might shrink to insufficient levels.

If she needed additional income, she could work five to 10 hours a week in her 70s to supplement the draw from her savings and Social Security. Working will also give her social contacts and purpose in life, and some evidence shows that working might also improve her health and longevity.

And speaking of longevity, at age 85 the QLAC starts, and most likely she won't be working by then. Her total retirement income would then be as follows:

  • $3,190 from the QLAC
  • $2,828 from Social Security, plus cost-of-living increases until age 85
  • Draw from remaining savings under the RMD rules

Note that if she lives to age 85 when the QLAC kicks in, she should still have savings in the assets that are invested and subject to the RMD rules. This gives her a safety cushion she can use for medical expenses, which will most likely increase in her later years.

She could also choose variations in this strategy. For example, she could devote less money to a QLAC, say $50,000 instead of $75,000, which would give her a higher retirement income until age 85 and lower income thereafter. She could also choose to work more than five to 10 hours in her 70s if she needs extra income.

This example shows that it takes a lot of money, plus smart decisions during your working years, to retire with enough funds to live the life you've planned.

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