retirement

How to manage money in early retirement

Congratulations: The years you've spent maxing out your tax-advantaged retirement accounts and diligently socking money into after-tax savings have paid off and you're able to retire well before you're old enough to collect Social Security or pensions.

Now the challenge is how to manage money in early retirement: specifically, figuring out how to withdraw income from your investment portfolio to support you until normal retirement age, while still allowing for growth to supplement expenses down the road. You need a retirement income bridge -- a stream of income from your portfolio to last until pensions and Social Security help fill in the gaps.

Lots of money locked in US retirement accounts | Lock: © Kitch Bain/Shutterstock.com, Money vector: © KennyK/Shutterstock.com

We asked three experts to help us with tips on how to manage money for a hypothetical 55-year-old couple who plan to retire early. Their money is split evenly between after-tax and pretax accounts. Their goal is to maximize tax benefits in their retirement accounts for as long as possible, maintain investment growth and withdraw a steady stream of income.

Determine how much you'll need

From the start, you'll need to plan for the next stage of life and potentially 40 years in retirement. "The first step is to take inventory and see what your allocation is. Look at all the pieces," says Jason Flurry, president of Legacy Partners Financial Group. "Second, you'll need to plan for a long time frame. We usually figure age 92 for women and 90 for men."

Before taking the early retirement leap, couples will need to get a handle on how much they actually spend and how much they expect to spend in the years ahead. "Every person is going to be different in what their true budget is," says Leslie Corcoran, founder of Family First Financial Planning. "What is this number -- is it $35,000 or $150,000 per year? That's going to be a big key to your portfolio lasting 40 years."

Flexibility is essential

The order of withdrawal should be taxable accounts first, allowing the tax-deferred accounts to grow. To ensure that a couple doesn't run out of money, approximately 3 percent to 4 percent would be considered a safe range for annual withdrawals, the experts agree. That leaves room for inflation and some growth in your investments during most years.

But, as with most rules of thumb, there are no guarantees and early retirees have to be flexible, allowing for market swings and accounting for personal spending habits. "The first few years of retirement matter a lot," says Scott Keller, investment specialist and principal at Truepoint Wealth Counsel. "You have to calibrate your withdrawals to your expenses, with 3 percent as the average over the retirement period. In reality, we often see it higher in the beginning and then it drops down."

Have a cash cushion

If a high withdrawal rate is paired with a market downturn, early retirees who are spending a lot in the beginning could be in trouble. To mitigate losses in such an event, Keller suggests to his clients that they maintain a minimum of five years of living expenses in short-term bonds and cash. "Then we feel comfortable with them taking risk," he says.

"We had a pretty quick recovery in the market after the 2008-2009 recession," he says. "In a typical business cycle, it's a five-year period. You don't ever want to be forced to sell stock at a depressed level."

Once you have a cash cushion -- anywhere from two to five years of living expenses, according to our experts, depending on how much risk you can stomach and how expensive you anticipate the first few years of retirement will be -- think of your investments in terms of buckets, says Corcoran.

Fill the buckets

See how a 55-year-old couple uses the bucket system to invest $2 million

The first bucket is for your cash reserves. It's designed for easy access and safety and contains an after-tax mix of liquid cash and short-term fixed-income assets. Yield is difficult to find, so you'll have to shop around for the best rates, Corcoran adds.

The second bucket is for intermediate-term needs, within five to 10 years, and ideally is also part of your after-tax portfolio. Here, you'll err more on the side of safety but allow for some investment growth.

The third bucket is for pretax investments that you would prefer not to tap into for 10 years or more. That's your bucket for growth because any market dips will likely have some time to recover. However, you won't want to take on too much investment risk.

As with the years leading up to retirement, the years in early retirement will require the right asset allocation.

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