This article is an excerpt from our ebook “How Are You Going to Pay for Retirement?” Download the ebook here.
Retirement is a long and expensive part of life. You can do whatever you want with it – keep working, travel, write a book, go skydiving. Whatever you do, your life will look different than it did before retirement, and the same goes for your finances. Your primary source of income will no longer be your salary. Your income will come from multiple sources that you need to understand well enough to avoid serious tax hits and make sure your lifestyle is properly funded.
How Are You Going to Pay for Everything?
Well, the fun part of retirement planning is over. You’ve figured out what you want to do in retirement, now you need to think about how to actually pay for it. This is where many people get overwhelmed with the details, but we’re here to help break things down into approachable pieces.
Income flows from two sources in retirement – money coming in and money going out.
Money Coming In
Just because you’re retired doesn’t mean you won’t have any income. Besides Social Security and any pensions you might have, many retirees continue working as either consultants or in a second career.
With Social Security, there are a couple things to consider. The first question people always ask is if it is something they should rely on when they are planning for retirement. We don’t think there is much risk of Social Security drastically changing. There might be some changes around the edges, but most likely any real changes will not affect folks who are close to retirement. Let’s focus on how to make the most of Social Security.
Depending on your exact situation, you have a number of possible strategies for when and how to claim. The general rule is this: The longer you defer claiming, the more money you’ll get. You’ll want to weigh the risks of tapping your investment portfolio earlier against receiving a higher Social Security payment. This makes sense for many people, but every case is different.
If you’re lucky enough to have a pension coming, you’ll most likely have two options for dealing with it. While the details differ with each pension, there are two general options:
- Take your pension as a lump sum, which you can then manage however you want; or
- Take it as an annuity that will pay out over a designated timeframe.
Deciding between an annuity and a lump sum may be complicated, depending on your particular pension, but the choice often boils down to two factors: the stability of receiving an annuity check in the mail, and what you can do with the lump sum your pension offers.
Annuity Pros and Cons
Knowing a check will show up at your door every month can provide a sense of security. For some people, this gives important financial peace of mind that allows them to focus on enjoying retirement. In deciding if this is the right course for you, consider these questions:
- Will your spouse continue receiving payments if they live longer than you?
- Will the payments be adjusted for inflation or will it pay the same amount forever?
- Will you get payments for life or for a certain number of years?
- How stable is the organization backing the annuity?
Make sure you understand the answers to all these questions before deciding whether or not to take the annuity.
The stability of the annuity option has a downside. In many cases, though not all, the lump sum will actually be worth slightly more from a purely financial perspective than the annuity offered. This is because you are paying for the stability of receiving monthly checks over time. The organization responsible for the annuity is taking on investment risk and has to provide these stable payments, so they need to be compensated. It’s the same thing with a bank – they pay lower interest on their deposits than they get back on loans.
Lump Sum Pros and Cons
You’ll want to think about a couple things when you’re considering the lump sum option:
- How disciplined are you going to be with this money? Will you be able to keep it invested?
- How much risk are you willing to take on? Taking the lump sum means accepting more investment risk, even if you just invest everything in bonds.
- How much flexibility are you comfortable with in your income? You can make the lump sum last much longer if you are willing to spend less when investment returns are poor.
Taking the lump sum means accepting more responsibility for your own retirement. This means you can end up with more resources throughout retirement, but it also means you don’t have the stability you get from knowing there’s a check coming every month.
Every plan handles this trade-off differently, and there are always details that may make your decision more complicated. Do your research before you do anything – especially since this is often a decision that you cannot reverse.
Working in Retirement
Many people find that working in retirement serves two purposes – it brings in more money and it provides a much-needed outlet. Put simply, it can be hard to quit work cold turkey; it’s been a major part of your life for many years. Working in retirement can offer social connection, it can be a way to feel useful, or it could just be doing something you enjoy. You don’t need to keep doing the same type of work you did in your pre-retirement career. While many retirees will work part-time or as a consultant in the area of their former career, it’s also common to start a second career. Just like everything else in retirement, what you decide to do is up to you.
Aside from the intangible benefits, working in retirement can significantly help you pay for retirement. Any money you earn is money that is not coming out of your portfolio. This gives the money in your portfolio even longer to grow. From your money’s point of view, this is like delaying your retirement – on your own terms.
Investments in Retirement
Investing in retirement is different than investing before retirement. You’ve spent your whole life saving money and building up your portfolio, now you need to live off that portfolio. While your basic investment approach should stay the same, there are a whole host of new issues to stay on top of when thinking about your portfolio.
The basic principles of investing are exactly the same before and after retirement. Risk and return are still related. Your asset allocation still determines your performance. You still want to make sure your portfolio is well diversified, is focused on harvesting market returns, and is built for the long term.
Just as before, the amount of risk you’re comfortable taking – your risk tolerance – is the driving factor in creating your portfolio. Figuring out your risk tolerance is never an easy task, but it gets even more complicated in retirement. Your risk tolerance during your working years was really about making sure you could stay invested through both bull and bear markets. That’s still true in retirement, but there are a couple of new wrinkles and one whole new issue to consider.
Most people think about their portfolio differently during retirement than they do when they are saving for retirement. While you’re saving, the market is bouncing around, and while it’s not fun, it’s not something that directly affects your ability to live the life you want to live. You’re still earning money and you have time to adjust.
You don’t have those luxuries in retirement. In most cases, you aren’t going to be able to add to your portfolio. Any time the market drops, that’s money out of your pocket. As a result, most people invest more conservatively in retirement.
You’ll also have something new to think about: sequence of return risk. While you’re saving – assuming you are able to stay invested – the order of annual returns doesn’t matter much. That’s not the case in retirement. Current activity in the market directly affects the portion of your portfolio you’re able to spend. If the market goes down, you’re spending a larger percentage of your portfolio than if the market does well.
Given the new challenges your portfolio faces, as well as the fact that most people are more risk averse in retirement, many investors make their portfolios more conservative. There’s no right or wrong answer here, but now is a good time to reassess your risk tolerance and adjust your portfolio accordingly.
Money Going Out
Withdrawing from your investment portfolio in retirement is like walking through a minefield. If you don’t choose the right path, you’re going to take a large tax hit. Most people don’t think about it, but your distribution strategy in retirement and the resulting taxes can significantly impact how long your money lasts and how much you can spend. Like asset location, withdrawal sequencing is an area where it’s easy to lose your way, but you can avoid major pitfalls by sticking to a couple guidelines.
Standard Distribution Order
Taxes are the driving factor in withdrawal sequencing. In order to maximize after-tax spending, you have to maximize the benefits of your tax-advantaged accounts.
Investment accounts fall into three main tax categories:
- Taxable accounts – Your standard brokerage accounts. Funded with after-tax money. Taxes are paid on capital gains and any income that comes from the account.
- Tax-deferred accounts – Accounts like your 401(k), 403(b), and traditional IRA. Funded with pre-tax money. Money is taxed upon withdrawal, generally at ordinary income tax rates.
- Tax-exempt accounts – Accounts like your Roth 401(k) and Roth IRA. Funded with after-tax money. but you don’t owe any taxes when you take the money out.
Just like anything with taxes, withdrawal sequencing has a number of exceptions and wrinkles to consider, but this is a good starting place.
If all of your investment accounts are the same type – for instance, all of your savings are in a 401(k) and traditional IRA – then you really don’t have much to worry about as your distributions will all be taxed the same way. Most retirees have more complicated situations.
This is a good basic distribution order to stick to (we’ll delve into the exceptions next):
- Any income you receive (Social Security, pensions, etc…), and your RMDs
- Taxable accounts
- Tax-deferred accounts
- Tax-exempt accounts
This gives your tax-advantaged accounts more time to grow before you start taking money out and it helps you achieve a higher level of potential after-tax income.
Issues to Consider in Withdrawal Sequencing
Now for the exceptions: estate considerations and Roth conversions. Other special cases exist but these are the two big ones.
If you’re planning on leaving money to others after you pass, you might want to leave your taxable accounts alone. If you have taxable investment accounts in your estate, their basis gets reset to the current value, meaning all of the unrealized capital gains taxes you owe in the portfolio go away and the recipient(s) of the assets essentially start fresh. This is known as a “step up” in cost basis. This can be a pretty big deal, depending on how long you have owned everything in your account.
Roth conversions might be something to consider, too. This is accomplished by taking money from your traditional IRA, paying the taxes on it, and moving it to your Roth IRA. You could pay a lower tax rate on the amount you’re converting and then have that money grow tax-free in the future. This can be especially useful in a year where you will have an unusually low income amount. This is a powerful approach when combined with your charitable giving strategy, especially if you are considering funding a donor advised fund.
A lot goes into optimizing retirement distribution order, but the basics are reasonably straightforward. As a first approximation, you want as much tax-advantaged growth as possible. This will allow you to spend more in retirement and leave more behind when you pass.
Watch Your Required Minimum Distributions
Retirement doesn’t necessarily mean life gets simpler. Sure, some things go away – commuting, waking up early, working – but other concerns take their place. One of those new things you need to think about is how to deal with your required minimum distributions (RMDs).
What is an RMD?
You need to take RMDs from some (but not all) of your retirement accounts starting the year you will turn 70 ½. Essentially, the IRS doesn’t want you to be able to just keep money in your retirement accounts and avoid paying taxes on it. They want to get paid, and that can only happen when you take money out of those accounts. You’ll need to take RMDs from your traditional IRAs, 401(k) plans (both traditional and Roth), and any other employer-sponsored retirement plans. Notice that this does not include your Roth IRA. This creates some planning opportunities we will discuss later.
To figure out how to calculate the amount you’ll need to take out, see our article “What is an RMD?”
Missing your RMD is Costly
It’s important to know how much you need to take out as there are significant penalties if you get it wrong. You’re always able to take out more money from your retirement accounts, but if you take out less than your RMD from any account, the penalty is half of your under-withdrawal. In other words, if you have an RMD of $20,000 from an account, but you only take out $10,000, you will owe the IRS an additional $5,000. It pays to double check what your RMDs are.
What if I Don’t Spend All of My RMD?
Sometimes your RMDs add up to more than you would spend in a year. The IRS doesn’t care – you still need to take the RMDs or face the penalties. But the money just needs to come out of the retirement accounts – you can do whatever you would like once you take it out, including putting it right back into your investment account. As long as you’re putting the money into a taxable investment account the IRS is happy – they’ve gotten their money.
Minimizing Your Future RMDs
Your future RMDs can be minimized in two ways: you can consciously build your investment portfolio so your high growth assets are not in accounts affected by RMDs, and you can utilize Roth conversions to move money into a Roth IRA.
Asset location is a pretty complicated area, but it boils down to structuring your portfolio to maximize your after-tax returns. Generally, this means putting your bonds in your traditional IRAs and 401(k)s. Because bonds tend to have lower expected returns, the accounts you’ll need to take RMDs from will grow more slowly than traditional taxable investment accounts, Roth IRAs and 401(k)s.
If you’ve paid attention to this since you started saving, you’re probably in good shape with regards to your RMDs. Even if you haven’t, this is something anyone can take advantage of to keep their RMDs from growing too fast in the future. If you want more information on the subject, take a look at our article on asset location.
Just like with distribution order, Roth conversions can also be a great way to minimize your future RMDs. As we stated before, the basic idea of a Roth conversion is to take some of the money you have in a traditional IRA, pay taxes on it, and then move it into a Roth IRA. It can be a powerful planning tool but requires some serious thought.
Roth conversions are often done in early retirement when you have a lower amount of taxable income than normal to keep the tax hit from the conversion lower – especially if you have chosen to delay claiming social security. Often during this period you are taking distributions from your taxable investment portfolio, so you won’t have much in the way of taxable income. While you are paying the taxes on this money sooner than you would otherwise, the fact that the taxes will be at a lower rate often means this will save you money in the long run – on top of reducing your future RMDs.
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