Take this simple step as you approach retirement

An important job in the two or so years leading up to retirement鈥攔ight up there with figuring out your healthcare coverage and winding down your work activities鈥攊s building up a cash cushion. In addition to being there as a source of funding when you eventually retire, cash has the salutary effect of providing a buffer if鈥� 鈥痙ue to unforeseen circumstances.

As you build out your , here鈥檚 .

Rightsizing Bucket 1

Your cash bucket should consist of one to two years鈥� worth of鈥痯ortfolio withdrawals, not living expenses. That鈥檚 because at least some of your living expenses will likely be coming from outside your portfolio鈥� or a pension, for example. And the composition of those cash flow sources may well change throughout your retirement.

To set up your Bucket 1 initially, think through your cash flow sources for the first few years of retirement. Let鈥檚 say a 66-year-old wants to retire in two years and expects that he鈥檒l need to spend $80,000 per year, in total, from his $1.5 million portfolio, at that time. He wants to delay filing for Social Security until age 70, so all of his spending will come from his portfolio in those first few years of retirement. After that, roughly half his spending needs will come from Social Security.

If he wanted to be conservative, he could build a cash cushion consisting of $160,000鈥攈is years 1 and 2 portfolio withdrawals. His Bucket 2鈥攈igh-quality bonds鈥攚ould consist of eight years鈥� worth of portfolio withdrawals, which at that point will be $40,000 per year (his $80,000 total spending less Social Security income). The remaining $1 million and change could go into a globally diversified equity portfolio.

Where to put the money?

In addition to thinking through the size of your liquid reserves bucket, it鈥檚 also worth considering the 鈥渨here鈥� of it. Will you hold cash in your taxable accounts, tax-sheltered accounts, or some in both? To help answer that question, you need to consider your鈥� .

Taxable accounts are often first in the queue for retirement withdrawals because their ongoing tax costs are higher than those of tax-sheltered accounts. (In a taxable account, you enjoy long-term capital gains tax treatment on the sale of appreciated winners you鈥檝e held for more than a year, but ordinary income is dunned at your higher ordinary income tax rate.) But some retirees may benefit from spending from their tax-deferred accounts early in retirement, with an eye toward reducing future required minimum distributions and tax bills. This is a good spot to get advice from a financial or tax adviser. Armed with the knowledge of where you鈥檒l turn for your spending in the first part of your retirement, you can then figure out where best to hold your liquid reserves.

Where to get the money?

Once you鈥檝e determined how much of a cash bucket you plan to set aside and where you鈥檒l hold it, the next step is figuring out how to build it up. Ideally, you鈥檇 give yourself a couple of years to enlarge your cash position rather than having to find the money just before retirement. Many people moving into retirement will have a few options.

Additional savings:鈥疐or preretirees who are still saving, a logical way to begin bulking up cash is to direct new contributions into cash. Say, for example, the aforementioned retiree is making the maximum allowable 401(k) contribution of $32,500 and putting another $8,600 into an IRA. By directing two years鈥� worth of contributions to cash in those two accounts, he could arrive at nearly half his target cash allocation ($82,200 of his $160,000 target) by the time he reaches his retirement.

Bonuses and inheritances: If you鈥檝e recently received a surprise cash injection, the assets are a logical source for bulking up cash reserves. They鈥檙e probably already in cash and in a taxable account.

Rebalancing: Trimming equities and adding those assets to cash and bonds provides a twofer for people closing in on retirement: It reduces risk and helps cover cash flows for the first few years of retirement. This kind of selling can trigger a tax bill, so get some tax advice and/or concentrate rebalancing in tax-sheltered accounts to lessen the impact.

Reducing risky positions:鈥疎ven if your portfolio鈥檚 asset allocation doesn鈥檛 need adjusting, you may still have problematic holdings in your portfolio: the employer stock you know you should scale back on, the individual-stock portfolio that鈥檚 duplicative of what鈥檚 in your mutual funds, or the costly active fund that hasn鈥檛 earned its keep relative to an inexpensive exchange-traded fund. Such holdings can be ideal sources when building up your cash reserves, just mind the tax consequences if you鈥檙e selling them from a taxable account.

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This article was provided to The Associated Press by Morningstar. For more retirement content, go to .

is director of personal finance and retirement planning for Morningstar and co-host of .

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