The Key 401(k) Rule To Follow 3 Years Before You Retire

Investing in a 401(k) plan comes with plenty of risks, but you might overlook one key danger.

Once you are within three years of retirement, the decisions you make carry high stakes. If you do something wrong at this time, you would have less time to recover from your error.

Find out why the three-year period before ending work is such a crucial time for seniors who hope to keep more cash in their pockets.

Beware the 'retirement risk zone'

The three-year period prior to retirement fits squarely into what is commonly known as the "retirement risk zone." This is a 10-year period that includes the years just prior to and just after retirement.

A reality known as "sequence of returns risk" is what makes this period so fraught with danger. If the market takes a dive during the retirement risk zone, it could damage your portfolio significantly, leaving you with less cash when you really need it.

Sequence-of-return risk can be especially devastating early in retirement because it forces you to make withdrawals on an already depleted nest egg. By the time the market recovers, you will have already spent the money, meaning your losses would be permanent.

How to build more safety into your portfolio

Nobody can predict the future. The stock market has performed well in recent years, but that doesn't mean danger isn't lurking around the corner. Bear markets can strike at any time.

Once you accept this truth, you can begin making decisions that mitigate the risks you face.

For example, if you are within three years of retirement, you might shift some of the investments in your 401(k) into stable, liquid assets.

How much safe money should you hold?

Experts vary in their recommendations for how much money you should hold in cash and other safe places.

T. Rowe Price recommends holding enough cash and short-term bonds to cover one to two years of expenses beyond guaranteed income, such as Social Security.

With Morningstar's bucket framework, you keep money you expect to need in the next few years in cash.

Money earmarked for the middle years of retirement can go into high-quality bonds with terms ranging from short to intermediate. Longer-horizon money can go into stocks.

Striking the right balance

Striking the right balance is the key to staying safe when you are in the retirement risk zone. If you're too conservative, you could run out of money in a retirement that may last 30 years. If you are too bold and take too many risks, your portfolio could take a major hit at a time when you don't have a lot of time to recover.

Perhaps you will focus on an amount that can cover the first one to three years of planned withdrawals before you retire.

This way, a market downturn early in retirement won't force you to sell equities at a loss just so you can fund living expenses.

Additional steps to consider

After you have reduced some of the danger that is part of the retirement risk zone, it's time to look at additional ways to shore up your portfolio ahead of your golden years.

These are things you can do in the three years before retirement that will increase your odds of keeping your retirement portfolio safe and growing. They include the following.

Confirm your RMD start date

For most people nearing retirement today, required minimum distributions (RMDs) begin at age 73.

However, many of those retiring a bit further down the road will first face RMDs at age 75. That will become the official RMD age in 2033.

Knowing exactly when your RMDs are slated to begin might help you craft a long-range withdrawal strategy that minimizes your tax burden.

Weigh the potential for Roth conversions

Some retirees who have money parked in traditional IRA or 401(k) plans decide to convert their holdings to a Roth IRA.

This will trigger extra taxes in the year of the conversion, but will also increase your ability to make tax-free withdrawals in the future.

The years between retirement and the start of your RMDs are often the single most valuable tax-planning window for making Roth conversions.

Review beneficiary designations

Even before you retire, it is wise to take a closer look at estate planning. In particular, make sure beneficiary designations reflect your wishes for what happens to your money after you die.

You worked hard to earn your money, so make sure it is going to the people and causes you care about most.

Establish a written withdrawal order strategy

Finally, the order in which you withdraw money from traditional, Roth, and taxable accounts can have a big impact on how much you pay in taxes and how long your money lasts.

So, create a written withdrawal order strategy that helps you make the most of your resources. Having this plan in place three years before retiring is crucial, as simply defaulting to a 401(k)'s current allocation rarely produces an optimal outcome.

If you are unsure about this step, consult with a financial advisor.

Bottom line

The three years before retirement are a crucial period that can set the template for your golden years. Planning well at this time can get your retirement off on the right foot.

So, put together a retirement plan that makes sense for your wants and needs and get ready to make the most out of post-work life.