Among the most critical financial moves to make in the two years before you retire — right alongside sorting out healthcare and easing out of your career — is accumulating a solid cash reserve. Beyond serving as a funding source once you’re retired, that cash buffer can be a lifesaver if circumstances force you to leave the workforce earlier than planned.
When constructing what financial planners call a “Bucket” portfolio, there are three key questions to address: how much cash to set aside, where that money should come from, and where it should be held.
The amount in your cash bucket should cover one to two years of portfolio withdrawals — not your total living expenses. The distinction matters because a portion of your retirement spending will likely come from outside your investment portfolio, such as Social Security benefits or a pension. Those outside income streams may also shift over time throughout your retirement years.
To get a clearer picture, consider this example: A 66-year-old planning to retire in two years anticipates needing $80,000 annually from a $1.5 million portfolio. Because he plans to wait until age 70 to claim Social Security, all spending in those early retirement years will come from his portfolio. After Social Security kicks in, roughly half of his spending needs will be covered by those benefits.
Taking a conservative approach, he could set aside $160,000 in cash — representing the first two years of portfolio withdrawals. A second bucket of high-quality bonds could cover eight years of withdrawals, which at that stage would be $40,000 per year (the $80,000 in total spending minus Social Security income). The remaining $1 million or so could be placed in a globally diversified stock portfolio.
Beyond the size of your cash reserve, you also need to think about where you’ll keep it — in taxable accounts, tax-sheltered accounts, or a combination of both. That decision ties closely to the order in which you plan to tap your accounts during retirement.
Taxable accounts are frequently the first to be drawn down in retirement because they carry higher ongoing tax costs than tax-sheltered accounts. In a taxable account, profits on investments held longer than a year are taxed at the lower long-term capital gains rate, but other income is taxed at the higher ordinary income rate. That said, some retirees may find it beneficial to draw from tax-deferred accounts early in retirement to reduce future required minimum distributions and tax obligations. A financial or tax adviser can help determine the best approach for your situation.
Once you’ve settled on how much cash to hold and where, the next step is figuring out how to build it up — ideally over a couple of years rather than scrambling to find it right before retirement. There are several common ways to grow your cash reserves:
Redirect new savings to cash: If you’re still contributing to retirement accounts, consider routing those contributions into cash. In the example above, if the retiree is contributing the maximum $32,500 to a 401(k) and $8,600 to an IRA, directing two years of those contributions to cash could get him nearly halfway to his $160,000 target — roughly $82,200 — by the time he retires.
Use windfalls wisely: Bonuses, inheritances, or other unexpected cash infusions are natural candidates for padding your cash reserves. These funds are often already in cash and sitting in a taxable account.
Rebalance your portfolio: Selling off some stock holdings and shifting the proceeds into cash and bonds serves a dual purpose for those nearing retirement: it lowers overall risk while helping to fund early retirement expenses. Be aware that selling can trigger a tax bill, so consider doing this rebalancing within tax-sheltered accounts when possible.
Trim problematic holdings: Even if your overall portfolio allocation looks fine, you may have specific investments worth reconsidering — such as a heavy concentration in employer stock, individual stocks that overlap with mutual funds you already own, or expensive actively managed funds that haven’t outperformed cheaper alternatives. These can be good sources of cash when building your reserve, though tax consequences should be carefully considered if they’re held in a taxable account.
This article was provided by Morningstar. Christine Benz is director of personal finance and retirement planning for Morningstar and co-host of The Long View podcast. For more retirement content, visit https://www.morningstar.com/retirement.
