You spent years feathering your nest egg: tracking your investments, adjusting your allocation and sacrificing a percentage of your paycheck every month to finance a comfortable retirement.

Who knew that would be the easy part.

“The biggest challenge for people in retirement is recreating the income streams they had when they were working,” says Daniel D’Ordine, a Certified Financial Planner with Life and Wealth Planning in New York. “You have to figure out how to take your assets and turn them into income by taking withdrawals, selling your investments or purchasing an annuity.”

Indeed, the complexity of tapping a mixed bag of retirement assets, from personal savings to pensions to IRAs and 401(k) plans, is compounded by a litany of distribution requirements, potential penalties and tax liabilities.

It’s made harder still by who’s in the Oval Office.

“The general level of tax rates can and does change over time in response to economic conditions, the agenda of the reigning political party or current and expected budget deficits or surpluses,” notes Stephen M. Horan in his study, “Optimal Withdrawal Strategies for Retirees with Multiple Savings Accounts,” featured in the Journal of Financial Planning.

Therefore, retirees must learn to adapt their withdrawal strategy to a changing tax environment by managing their tax-advantaged accounts, such as IRAs and 401(k) plans, says Horan, head of professional education content and private wealth for the CFA Institute.

Creating an income stream
  1. Determine your withdrawal rate.
  2. Divide assets into buckets.
  3. Be mindful of taxes.
  4. Consider Social Security.

Determine your withdrawal rate

Before you can decide which accounts to tap first, you’ll need to crunch the numbers to determine how much you can safely withdraw without running the risk of outliving your cash.

Your withdrawal rate, in fact, is the most important piece of your post-retirement financial plan.

To develop a sustainable strategy, you’ll need to consider your age, life expectancy, living expenses and rate of return on your investments.

For retirees with all their ducks in a row, meaning they didn’t retire before age 65, they have adequate savings set aside and are generally healthy, D’Ordine says a good rule of thumb is to draw down no more than 4 percent of their portfolio each year, adjusting that rate gradually higher to account for inflation.

For example: If your nest egg is worth $1 million, you would withdraw 4 percent, or $40,000, the first year. Assuming an annual inflation rate of 3 percent, multiply that amount by .03 percent, yielding a withdrawal amount of $41,200 the second year, $42,436 the third year, and so on.

Assuming a conservative 8 percent return on your overall portfolio and a generally stable economy, that strategy allows you to spend only your earnings, leaving your principal untouched.

If you retire early, or if you have to dip into your nest egg’s principal to sustain yourself for several decades, use Bankrate’s retirement calculator to determine how much you need to have saved. You may have to dial back your withdrawal rate and supplement your income by working part-time for awhile.

You should also reduce your withdrawal rate if your portfolio has fallen significantly in value, says D’Ordine.

“After a year like 2008, where what was once a $1 million portfolio may now be worth $650,000, it’s best to take a step back and reassess,” he says, noting $40,000 is actually more than 6 percent of a $650,000 portfolio. “That rate of withdrawal could lead to the ultimate depletion of assets,” he warns.

Ideally, financial planners say your withdrawal rate should leave you with enough income to cover your living expenses until age 100, because many Americans are living longer and incurring greater medical costs than ever before.

Even so, Bob Adams, a Certified Financial Planner with Armstrong Retirement Planning in Cupertino, Calif., recommends retirees maintain an emergency fund worth at least 12 months’ of living expenses in an interest-bearing account, such as a CD or money market.

“An emergency fund must be liquid and safe, so this is money that should not be in the stock market,” he says. “You don’t want to be in a situation where you might be forced to liquidate equity investments during a downturn in the market.”

Divide assets into buckets

The next challenge, of course, is determining how to turn your assets into income.

D’Ordine says retirees can help put their nest egg into perspective by categorizing their assets into three distinct buckets.

The first, which includes investments outside of a retirement fund, is your taxable bucket.

Most planners, including D’Ordine, recommend retirees tap those investments first, since the capital gains tax rate may be more favorable than the ordinary income tax rate you will pay when withdrawing from such tax-deferred accounts as an IRA or 401(k).

Taxable accounts are also first to bat for those who retire early, because distributions from your IRAs and 401(k) plans usually involve penalties before age 59½.

The second bucket includes your tax-favored accounts, such as a traditional IRA or 401(k).

For many investors, it’s best to leave these funds untouched until their taxable investments are depleted, allowing them to accumulate tax-deferred as long as possible, says Adams, who says any withdrawal plan “has to be integrated into your overall retirement, tax-planning and estate planning” strategy to achieve your financial and nonfinancial goals.

Of course, you can’t let your tax-deferred accounts ride forever.

The Internal Revenue Service, anxious to get its share, requires you to begin taking minimum distributions (and paying the resulting tax) from your IRA, 401(k), simplified employee pension, or SEP, and SIMPLE accounts by April 1 of the year after you reach age 70½ .

Failure to take those distributions or withdraw a large enough amount results in a hefty 50 percent excise tax on the amount not distributed. It should be noted, though, that a new law passed in December 2008 waives the required minimum distribution for the 2009 tax year only, due to the recent market decline.

The third and final bucket includes your tax-free accounts, such as a Roth IRA. This is funded with after-tax dollars so earnings are tax-free once you reach retirement age. It’s generally recommended investors tap these accounts last, since there are no minimum withdrawal rules for a Roth and your earnings will continue to grow tax-free.

The other benefit to leaving your Roth for last? Roth IRAs provide valuable estate planning benefits since your heirs will not owe taxes on an inherited Roth and they’re able to spread out their withdrawals over their lifetimes, allowing the account to continue its tax-free growth.

Be mindful of taxes

Keep in mind, however, these withdrawal strategies are merely guidelines.

Some studies suggest that a more managed approach, which accounts for tax law changes, can improve the sustainability of your portfolio.

Horan’s study for the Journal of Financial Planning, for example, finds that in a tax rate environment characterized by variability, making traditional IRA withdrawals when tax rates are low and Roth IRA withdrawals when rates are high performs “especially well.”

“Because distributions from traditional IRAs are taxable and those from Roth IRAs are not, it is advantageous to make withdrawals from traditional IRAs when the tax burden is light and to make withdrawals from Roth IRAs when the tax burden would otherwise be heavy,” he writes, adding that retirees “can benefit from having multiple types of tax-advantaged retirement accounts from which to draw” during their retirement years.

The study further concludes that if your IRA distributions comprise the bulk of your retirement income, your withdrawals will likely be subject to a series of progressively higher tax rates in any given year.

Because taxable distributions can be applied against personal exemptions, deductions or lower tax brackets, the strategy of withdrawing from the traditional IRA first produces substantially larger portfolio accumulations over time, Horan says.

Better yet, take traditional IRA distributions that would be taxed at rates up through 15 percent and satisfy the remainder of the required minimum distribution from your Roth IRA. Such a strategy “yields residual accumulations that are 20 percent to 40 percent greater than” selecting a single account to tap (and deplete) first, he found.

Translation: Your money will last significantly longer if you take a blended approach to meeting your required minimum distributions.

“Retirees can significantly improve the sustainability of their retirement portfolios by embarking on an optimal withdrawal program,” Horan says.

“I’m not a prophet with respect to future tax rates, but conventional wisdom suggests that we have no choice but to raise taxes going forward because of recent commitments made (by President Barack Obama) and the state of the economy,” Horan says. “So if you think rates are going to be higher in the future, then that would argue for taking some of your taxable distributions (from a traditional IRA or tax-deferred retirement plan) now before rates go up.”

Consider Social Security

Yet another decision facing the newly retired is when to begin drawing Social Security.

The earlier you collect, the less you receive.

For example, the minimum age for drawing Social Security benefits is 62, but you receive a permanently reduced benefit by collecting before your full retirement age, which ranges from 65 to 67 depending on the year you were born.

Social Security benefits by age
The longer you wait to collect Social Security benefits, the more you receive. If your full retirement age is 67, the reduction for starting your Social Security at age:
  • 62 is about 30 percent
  • 63 is about 25 percent
  • 64 is about 20 percent
  • 65 is about 13.3 percent
  • 66 is about 6.7 percent
Source: Social Security Administration

At full retirement you are eligible to receive 100 percent of your benefit, but you can delay benefits even longer if you choose, making the size of your Social Security checks larger still — up until age 70.

Most financial planners recommend delaying benefits as long as possible, especially if you undersaved for retirement because Social Security is your last, best chance to boost your income.

But that only makes sense if you’re healthy. If you’re facing a significant reduction in life expectancy due to illness and you need the money, it may make sense to begin collecting Social Security as soon as possible, despite the reduced benefit.

Remember, too, that if you continue to work during retirement, you must consider your income to determine whether it’s wise to claim Social Security or wait until you quit.

According to the Social Security Administration, if you have substantial outside sources of income (either from wages, self-employment, interest or dividends), you may have to pay federal income tax on your Social Security checks — up to 85 percent of your benefit.

If you file a joint return, for example, and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits. If you make more than $44,000, up to 85 percent of your benefits may be taxable.

You can lower your taxable income during retirement by taking proceeds from both taxable accounts and Roths, which in turn helps minimize the taxation of your Social Security benefits, says Adams.

As you map out your retirement withdrawal strategy, make sure you take the time to understand the rules, penalties and tax liabilities associated with each of your accounts.

And don’t forget, the trick to making your nest egg last is not the size of your account, but how well you manage what you’ve got.