Why liquidity matters in the five-to-ten years before retirement
As people approach retirement, the consequences of being unable to access cash—because of market losses, taxes, or penalties—become much more acute. A prolonged market downturn that occurs as you start withdrawing from savings can force you to sell stocks at depressed prices, a problem known as sequence-of-returns risk. A liquidity-aware allocation reduces the chance you’ll have to sell long-term assets at unfavorable prices and gives you a clearer runway to convert investments on your timetable.
This guidance is current as of 2025 and focuses on U.S. retirement rules and markets. It is educational and not individualized financial advice; consult a certified financial planner for a tailored plan.
Sources to consult: the SEC’s retirement planning guidance (https://www.sec.gov) and the Federal Reserve’s reports on household finances (https://www.federalreserve.gov) provide background on retirement risk and household liquidity.
Practical components of a liquidity-aware allocation
A liquidity-aware approach explicitly grades each asset on two dimensions: expected return and liquidity (how quickly and cheaply it can be converted to cash). Key components include:
- A short-term cash runway (emergency fund and near-term expenses).
- A bucket or ladder strategy for conversion timing (cash, short-term bonds, intermediate fixed income).
- Tax and penalty planning (tapping accounts such as taxable brokerage, Roth conversions, and qualified plan rules).
- Rebalancing and glide-path rules that shift allocations as retirement nears.
These elements are designed to keep you solvent and flexible while preserving growth potential.
The bucket strategy: a simple, widely used framework
A common design is the 3-bucket model:
- Immediate bucket (0–2 years): cash, high-yield savings, money market funds. Used for living expenses and shocks.
- Short-term bucket (2–7 years): short-duration bond funds, T-bills, short-term municipal or corporate bonds. These provide modest yield with limited price volatility.
- Long-term bucket (7+ years): equities, diversified bond portfolios, and growth-oriented funds intended to support long-term spending and inflation hedging.
The goal is to fund near-term withdrawals from the immediate and short-term buckets so you avoid selling long-term holdings in bad markets.
How much should be liquid? Rules of thumb and how to tailor them
Common guidance recommends 6–12 months of essential expenses in liquid accounts, increasing to 24–36 months for people with unstable income or large near-term liabilities. For near-retirees, a common portfolio split might look like:
| Asset Type | Typical Liquidity | Use Case |
|---|---|---|
| Cash / High-yield savings / Money market | High | 6–12 months of essential expenses; immediate needs |
| Short-duration bonds / T-bills | High–Medium | 2–7 years of planned withdrawals; laddered liquidity |
| Taxable brokerage investments | Medium | Buffer between retirement accounts and long-term growth; avoid penalties |
| Retirement accounts (IRA, 401(k)) | Low–Medium (taxs/penalties vary) | Long-term growth; strategic withdrawals and conversions |
| Real estate / illiquid assets | Low | Not reliable for short-term cash needs |
Adjust these ranges based on your other guaranteed income (Social Security, pension) and your health and long-term care risk.
Tax, penalty and timing considerations
Near-retirees should plan around key U.S. retirement rules:
- Withdrawals from traditional IRAs and 401(k)s are taxable; withdrawing before age 59½ often triggers a 10% penalty unless an exception applies. (See our glossary entry: Age 59 1/2 Rule for Retirement Accounts).
- Roth IRAs, when qualified, allow tax-free withdrawals of contributions and earnings after a waiting period; they can be used strategically for tax-efficient liquidity.
- Partial Roth conversions can be used to manage future taxable income and create a tax-free source of withdrawals, but they generate current taxable income.
Managing taxes and penalties is part of liquidity planning. For example, if you need cash at age 62 but are concerned about taxes, you might sell taxable investments first to preserve qualified account balances for required minimum distributions (RMDs) and tax-efficiency.
Sequencing risk and the role of liquid reserves
Sequencing risk means the order of investment returns matters. Negative returns early in retirement magnify the risk of portfolio depletion if you must sell assets to cover living expenses.
Holding a cash runway or short-term bond ladder allows you to draw from low-volatility sources during negative return periods, preserving long-term growth assets to recover when markets rebound.
Empirical studies and industry guidance highlight that liquidity buffers reduce the probability of running out of money in retirement and lower the need to take concentrated, high-risk positions to chase returns (SEC; Federal Reserve consumer finance surveys).
Designing an actionable plan (step-by-step)
- Calculate essential expenses: list fixed living costs, health insurance, and expected out-of-pocket health expenses.
- Map guaranteed income: Social Security, pensions, annuities. Subtract guaranteed income from essential expenses to see the shortfall.
- Build a runway: preserve 6–36 months of the shortfall in liquid instruments depending on income stability.
- Ladder short-term investments: use T-bills or short-term bond funds timed to known withdrawal years.
- Sequence withdrawals: draw from liquid funds first, then taxable brokerage, then tax-deferred accounts—unless tax planning dictates otherwise.
- Rebalance and update every 12 months and after major life events (job change, large medical expense, inheritance).
In practice, I’ve recommended a three- to five-year liquid runway for clients who transition from full-time work to partial or no work while they claim Social Security and manage RMD timing.
Common mistakes to avoid
- Underestimating health and caregiving costs. These are frequent reasons clients need more liquidity than they planned.
- Overreliance on retirement account withdrawals without planning for taxes and penalties.
- Treating liquidity and return as completely separate goals; you must balance both to meet spending needs and preserve growth.
How liquidity-aware allocation connects to other retirement rules and strategies
- Withdrawal strategy: Pair your liquidity plan with a withdrawal rule such as the 4% rule or a dynamic withdrawal strategy. See our glossary on The 4% Rule of Retirement Withdrawal.
- Account rollovers and timing: If you’re considering an IRA rollover, plan the timing so it doesn’t jeopardize your short-term liquidity needs (see Individual Retirement Arrangement (IRA) Rollover).
Linking these topics helps you integrate liquidity decisions into the full retirement plan.
Case example (anonymized)
A client, five years from planned retirement, had 90% of savings in equities and a small emergency fund. We modeled a 30% market drop in year one with a 4% withdrawal rate. Without a liquidity plan, they would have been forced to sell stocks at depressed values. We implemented a 3-year cash runway using high-yield savings and T-bill laddering, shifted a portion of fixed income into short-duration funds, and staged Roth conversion amounts to manage taxes. The result: lower sequence-of-returns exposure and a smoother income transition into retirement.
Frequently asked questions
Q: When should I start liquidity planning?
A: Ideally 5–10 years before your target retirement date, or sooner if you expect large expenses or job uncertainty.
Q: Does holding cash hurt my long-term returns?
A: Cash generally yields less than equities but reduces the risk of forced selling during downturns. The right balance preserves growth while protecting short-term cash needs.
Q: How does Social Security factor in?
A: Guaranteed income from Social Security reduces the amount you need to hold in liquid reserves for essential expenses. Include projected Social Security in your cash-flow map.
Sources and further reading
- U.S. Securities and Exchange Commission, “Retirement Planning” — https://www.sec.gov
- Federal Reserve, “Economic Well-Being of U.S. Households” and related reports — https://www.federalreserve.gov
- Consumer Financial Protection Bureau, guidance on emergency savings and household finances — https://www.consumerfinance.gov
Professional disclaimer
This content is educational and current as of 2025. It does not constitute individualized financial, tax, or legal advice. Tax rules (including penalties and required minimum distributions) may change; consult a certified financial planner, tax professional, or attorney for advice specific to your situation.
Author note: In my practice working with over 500 near-retiree clients, a tailored liquidity plan—usually combining a cash runway and a short-duration bond ladder—proved the most effective way to protect retirement income while preserving long-term growth potential.