As retirement approaches, one of the most critical tasks alongside planning for healthcare and winding down work is establishing a cash cushion. This cash reserve acts as a vital source of funding for retirement and serves as a buffer in the event of unexpected early retirement due to unforeseen circumstances.
When developing a bucket portfolio, it is important to consider the size, origin, and location of these liquid assets. Specifically, Bucket 1 should contain one to two years' worth of portfolio withdrawals, rather than strictly living expenses. This is because part of living expenses may come from outside of the portfolio, such as Social Security or a pension, which may evolve throughout retirement.
For example, a 66-year-old planning to retire in two years who anticipates needing $80,000 per year from a $1.5 million portfolio could consider a conservative approach by establishing a cash cushion of $160,000 for the first two years. His Bucket 2, which is composed of high-quality bonds, would consist of eight years' worth of withdrawals—approximately $40,000 per year, factoring in future Social Security income. The remaining portion of his portfolio could then be allocated into a globally diversified equity portfolio.
Aside from determining the size of the liquid reserves, it is crucial to consider their location—specifically whether to hold cash in taxable accounts, tax-sheltered accounts, or a combination of both. Taxable accounts are typically prioritized for withdrawals due to their higher ongoing tax costs compared to tax-sheltered accounts. Long-term capital gains in taxable accounts may be taxed at lower rates if the assets are sold after being held for more than a year. Nevertheless, some retirees may find it advantageous to withdraw from tax-deferred accounts earlier in retirement to minimize future required minimum distributions and associated taxes. Consulting a financial or tax advisor can provide valuable insights in making these decisions.
Once you have established how much you want to set aside for a cash bucket and where to hold it, the next step is figuring out how to build it up. Ideally, you would allocate a couple of years to increase your cash position instead of scrambling for funds right before retirement. Various options are available to those nearing retirement.
One strategy involves making additional savings. For example, a retiree still contributing to retirement accounts may direct new contributions into cash. If he is maximizing his 401(k) contributions at $32,500 and contributing another $8,600 into an IRA, he could potentially gather nearly half of his target cash allocation ($82,200 of a $160,000 target) in two years.
Other avenues for increasing cash reserves include tapping into bonuses or inheritances, which are typically already in cash and held in taxable accounts. Additionally, rebalancing an investment portfolio by selling equities and reallocating the funds into cash or bonds can serve dual purposes—reducing portfolio risk while covering cash flows for the initial years of retirement. However, such sales might incur tax implications, so it is advisable to seek tax guidance and consider executing these transactions within tax-advantaged accounts.
Lastly, consider reducing risky positions in your portfolio. Even if your current asset allocation remains appropriate, problematic holdings such as concentrated employer stock or high-cost funds can be excellent sources for building cash reserves. It is essential to take into account the potential tax consequences when divesting from taxable accounts.
Overall, careful planning in the final stages leading to retirement can ensure that individuals have the necessary financial resources available to support their lifestyle and handle unexpected situations.
