90% of retirees are making this miscalculation with their savings

By Beth Pinsker

The order in which you spend your money makes a difference for your taxes - and your enjoyment of life

Saving your IRA to spend last might not be the best financial decision.

When you retire, you ideally have a couple different buckets of money to draw from - like pretax, Roth, cash and Social Security - which helps you diversify your income sources and better manage your taxes.

But retirees are marking their IRAs and 401(k)s as off-limits for a decade or more, and then only taking from them sparingly, according to a new report from Vanguard, one of the biggest retirement-account custodians. This leads to people constraining their budgets early in retirement, and dying with even more money than they started with at the beginning of retirement.

It's a reactive strategy to calm the fear of running out of money, and it ends up working far better than they expect - which is actually counter to their intentions.

"In the savings phase, we do so much to help people auto-enroll, auto-invest - and when it comes to retirement income, we drop them in the Pacific Ocean and say, 'swim,'" said Fiona Greig, Vanguard's global head of investor research and policy. "Maybe it's no surprise to see people struggling."

Vanguard first saw this behavior in blind administrative data from the millions of accounts it manages. It could see that most people waited until they hit the age of required minimum distributions (RMDs) - 73 now, though it will be 75 for those born 1960 and later - and then they tended to only take out the required amount. That RMD is pegged to a government formula based on a person's projected lifespan, and it starts out at about 4% of the account value but is larger at older ages. Following that path of withdrawals and average account growth of 7%, a person would have a greater balance at the end than when they started.

"The end" in this scenario is literal - it's the end of the saver's lifetime. Then the question becomes: What's the point of retirement savings if you have more when you die than when you started retirement, and meanwhile you're living on peanut butter and jelly?

Greig said this is when her team decided to delve deeper, because just looking at back-end data didn't let them see if this was a true behavioral phenomenon, or if it was just a data artifact because Vanguard doesn't necessarily hold each participant's entire life savings. People regularly have accounts at several different institutions at the same time.

So Vanguard surveyed retirees across the income spectrum about how they spent through their entire retirement nest eggs. The results were shockingly the same: Only 1 in 10 retirees took consistent withdrawals from their accounts throughout retirement. Most took sporadic lump sums at times when they had large expenses, or they took one annual distribution once they hit RMD age - and took only the amount required.

The risk of this, Vanguard said, is that this strategy means "backloading income into later years," which can increase income taxes and lead to higher taxes on Social Security and possible monthly surcharges on Medicare, known as IRMAA. It also led to excess money at the end of life - a stated goal of only 1% of the respondents.

"As researchers, we think about smoothing consumption," said Greig. "But using the RMD amount as the retirement income strategy effectively means they go from earning to living on PB&J and just Social Security to having to take out substantial withdrawals, with substantial tax impact, when RMDs kick in."

Spend now or later?

With the data, Vanguard mapped out four different scenarios for a "typical" retiree, with the example of somebody who had $360,000 when they started retirement.

The most common approach was to wall off the pretax savings in IRAs or 401(k)s - or a combination of pretax accounts - and claim Social Security when they hit 62. That carried them until they hit RMD age at 73 or 75. That gave them about $48,000 in annual spending, and at the end of life (an educated estimate) they'd have $398,000.

The second and third options were for the hypothetical person to take regular monthly withdrawals from the $360,000, akin to a paycheck, or to annuitize 25% of their money. Either approach would free up a few thousand dollars more to spend each year. They'd die with less than they started with, because the paycheck would cost them some of their principal, but they'd still have $160,000 or more remaining.

The fourth option was the optimal smoothing that economists propose. Instead of claiming Social Security and waiting to take money from the pretax account, you'd flip that and take money out from your retirement savings for a "bridge paycheck" that would cover you until you turn 70. Your Social Security benefit would grow and by the time you claim, you'd have $56,000 to spend each year - the highest of all the strategies. It's also potentially much more for you to spend on yourself, rather than pay in taxes or Medicare charges along the way. When you die, you'd be projected to have about $44,000 left - not nothing, but not as much of a legacy.

"You're basically buying an annuity," said Aaron Goodman, a Vanguard researcher who worked on the report. "Purely in terms of returns, it makes a lot of sense, because the increase in Social Security by waiting is a guaranteed 7% to 8%. That's an attractive return."

That said, Goodman said that for people with more limited savings, if they have to spend down principal in order to delay, that might be limiting. "It comes down to a choice for the retiree," he said.

For Greig, the decision would be easy: Spend more now and not try to end up with more than she started with after she's gone.

"But that's really a question for each human being," she added. "We see people struggling to spend down their assets, and this is an area where we think more work needs to be done in terms of policy and plan design. We have to make retirement income easy, and the data is showing it's hard for people to do this."

Got a question about retirement? Fill out our new questionnaire or write to me directly at beth.pinsker@marketwatch.com (please put "Fix My Portfolio" in the subject line).

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-Beth Pinsker

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09-19-26 1440ET