Why You Need a Cash Reserve in Retirement
October 20, 2015 | Enjoying Retirement
When I’m asked about financial planning for retirement, people usually want to talk about the best way to accumulate retirement savings. That’s understandable; everyone wants to make sure he or she will be able to support a retirement that could last 30 years or more.
What many people tend to overlook, however, is the importance of planning how to create income with their money once they reach retirement. A well-designed income strategy can help protect you against the kinds of things that are not in your control but could potentially derail your spending power in retirement.
What do I mean by “an income strategy”? When you reach retirement, you’ll need to decide how to tap into each of your assets to create a stream of income for yourself. Say you retire with Social Security, a 401(k), a Roth IRA, permanent life insurance and an annuity. The order and timing in which you pull money from each of those assets can have a significant impact on how much money you will actually have to spend. For example, traditional retirement accounts will be taxed as you make withdrawals, but you can pull from a Roth IRA tax free. Ideally, you should have a mix of taxable and non-taxable sources of income so you can make withdrawals from them in a way that allows you to minimize your overall tax burden and maximize your income.
A well-designed income strategy will also help you avoid having to withdraw money from your investments when the market takes a downturn, as so many people had to do in 2008 and 2009. Instead, you want to be able to select when and how you’re accessing your investments and wait for a time when your assets are more highly valued. This is where an asset such as permanent life insurance can be beneficial. It accumulates cash value you can access in down markets, in most cases tax free.1
A key component of a good income strategy involves the creation of a cash reserve, a place where you can “park” money you’ve withdrawn from your assets in an account that’s easily accessible. You build up and replenish the cash reserve by making withdrawals from your assets only when it’s a good time to do so—in the case of your investments, for example, when you can “sell high.”
Ideally, you’ll keep a year or two worth of living expenses (not covered by Social Security, pension or annuity payments or RMDs from an IRA) in the cash reserve—typically a money-market or similar account—to pay your bills and cover unexpected expenses. Having this cash reserve ensures that the money you may need in the short term will be readily available and not subject to the ups and downs of the market or other factors out of your control.
When should you start doing all this? I typically encourage people to think about diversifying retirement savings from a taxation perspective early in their savings years. Then begin to build your cash reserve one to two years before you stop working.
While it’s possible to create a cash reserve on your own, the process of replenishing it can get complicated, depending on the types of retirement assets you have and how they’re taxed (if at all). It’s a good idea to work with a financial professional who can help you make the most of the money you’ve saved so you can live the life you envisioned in retirement.
1The primary purpose for life insurance is the death benefit. Using cash value to supplement your retirement income will reduce benefits and may affect other aspects of your plan.