4 Components of a Retirement Income Strategy
“How much money do I need to retire?”
This seems to be the most common question that comes up in developing a retirement plan, but is this the right question to ask?
The common belief is that retirement planning is all about getting to the peak; that the hard work and focus is behind us once we reach retirement. With so many media and investment firms focusing on the amount you need when you get to retirement, how to save for retirement, and a focus on stock or equity investments, it isn’t a surprise that we tend to lose focus on our finances when we make it to the top of the retirement mountain. However, retirement planning really gains a new importance and becomes more difficult as you start to develop a distribution strategy. When climbing a mountain, it is often coming down when people get in trouble.
Maybe the correct question to ask is:
“How do I work towards a retirement INCOME stream that matches my lifestyle goals?”
Last week we discussed three basic considerations in relation to retirement expenses and distribution planning. This week, we will take a deeper dive into more complex aspects of retirement planning. If addressed properly, the goal is to maximize what you have worked so hard for and minimize potential pitfalls. Here are 4 crucial strategies to address in retirement planning:
Taxation
The common advice is to defer taxes on income as long as possible. However, what this advice is missing is analysis on an individual basis. This general recommendation states that your current income is higher now than it might be in retirement. While this may be true for some people, many folks find that they actually end up with a higher income in retirement than they did in their working years. Between pensions, social security, and investment assets, taxable income can sometimes be higher than expected.
Another important tax consideration is the assumption that tax rates will stay the same, and the reality is we have no way to predict this. It is important to diversify taxes, just as you would diversify the investments within your portfolio, so you are prepared to make the most of any situation that may come up. Proper tax planning can save millions of dollars in taxes by being proactive and engaging in some precise long-term financial planning. With some clients, proper tax planning can be used to create a tax-free bucket for discretionary distributions as a way to “self-insure” against potential long-term care costs and other unexpected expenses in retirement.
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Required Minimum Distributions (RMDs)
If you are only saving to your pre-tax 401(k), you will find that at age 72 the IRS will force you to take distributions each year , called Required Minimum Distributions or RMDs, which are fully taxed as ordinary income. This may not be a huge issue if you need these dollars in retirement and do not have estate planning wishes. However, if you find these distributions are larger than your projected need for expenses, you may find yourself being forced to deplete your assets and pay additional taxes sooner than you had planned.
Also, if leaving a legacy to the next generation is important to you, this will deplete the amount you will have available to leave or minimize the flexible assets you have to handle any “unexpected expenses”. Even if you do pass down a pre-tax IRA or 401(k), whatever balance is left will also be fully taxed to your beneficiary as opposed to a potential tax-free inheritance. This is where a Roth IRA can be very helpful, as Roth IRAs do NOT require distributions (as it stands today), and when money is taken out, these amounts are fully tax-free.
Creating your own paycheck
Now that we no longer have an employer providing a paycheck, it is critical to start thinking about how you will create one for yourself. Developing an income strategy from your assets is extremely important as opposed to simply taking money out of growth in your account. It’s important to determine how much income your portfolio can create through fixed income and stock dividends to match up to expenses. Don’t get me wrong: it is still critical to have the right balance of assets to allow for growth, keep up with inflation, and minimize the impact of volatility, but this can be more complex than a general 60/40 portfolio (60% stock and 40% bonds).
Many clients struggle with the transition to retirement, and flexibility they now have, to take distributions from their account when and if they please. Although this flexibility is freeing, there is certainly something to be said around having a portion of your assets creating a fixed income to help stick to a budget in retirement and avoid taking out too much too soon.
Social Security
Social Security is complicated enough that entire books have been written to discuss the ins and outs. With many, many, different ways for a married couple to file for their social security benefits (believe it or not there are over 80 different combinations), this can be quite the complex world. Not only are there different benefits associated with different strategies, but it is critical to look at how these choices will impact your other assets as well. By truly understanding the coordination of ALL aspects of retirement, we can develop a plan that really enhances your retirement income and minimizes the tax impact over time. You may be catching a theme here, but the way other assets are distributed may also affect the taxation on any social security benefits received in retirement.
As we discussed, the media’s focus on retirement distribution is almost non-existent, but these areas will make or break a retirement plan. Hopefully, by implementing these four steps and proper ongoing planning, we can help avoid being forced back to work after retiring without a plan. Remember, this gives us a great starting point to create a solid distribution planning strategy, but it is essential to review this framework at least once a year to be sure your plan shifts along with your ever-changing life and goals.
Hopefully, you feel more equipped to develop a thoughtful retirement plan based on your needs. If you have questions about this article, or if we can be of service, be sure to get in touch with us!
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This post was last updated on May 18, 2021 to correct the RMD age based on legislation changes from the SECURE Act.