As individuals approach retirement, one critical aspect of their financial preparation is establishing a substantial cash reserve. This “cash cushion” serves not only as a ready source of funds upon retiring but also provides a financial buffer in case of an unexpected early retirement.

Financial advisors recommend that retirees hold between one and two years’ worth of portfolio withdrawals in cash, rather than basing that amount on total living expenses. This distinction accounts for other income sources such as Social Security benefits or pensions, which typically cover part of retirement spending and may fluctuate over time.

For example, a 66-year-old planning to retire in two years, with a $1.5 million portfolio and annual spending needs of $80,000 fully funded from the portfolio until Social Security begins at age 70, might target $160,000 in cash reserves to cover the first two years. Following that initial period, when Social Security reduces portfolio withdrawals to about $40,000 annually, bonds could be allocated to cover several years of spending, while the majority of the remaining assets would remain invested in a diversified equity portfolio.

Equally important is the decision regarding where to hold these cash reserves within one’s accounts. Taxable accounts often serve as the first source of retirement withdrawals due to their higher tax rates compared to tax-deferred or tax-exempt accounts. However, some retirees might benefit from drawing down tax-deferred accounts earlier to limit future required minimum distributions and reduce tax liabilities later in life. Determining the optimal withdrawal sequence is complex and generally merits consultation with financial or tax professionals to tailor strategies to individual circumstances.

Building the cash cushion ideally begins well before retirement, allowing enough time to accumulate sufficient liquid assets without disrupting investment goals. Methods to increase cash holdings include directing new retirement contributions into cash positions, reallocating bonuses or inheritances received, and rebalancing portfolios by trimming equity exposure and increasing allocations to cash and bonds. While rebalancing can reduce risk and free up funds for near-term needs, it may trigger taxable events, which should be managed carefully.

Additionally, retiring investors are advised to consider reducing exposure to high-risk or concentrated holdings, such as company stock or costly active funds, as sources for cash reserves. Such adjustments help mitigate portfolio risk and improve diversification but also require attention to potential tax implications when selling positions housed in taxable accounts.

Overall, establishing a well-planned cash bucket is a fundamental step in retirement readiness, offering both financial security and flexibility during the transition from work to retirement life.