As adults, we know the importance of saving for retirement. The concept is really easy. Just set up an automatic withdrawal from each month's paycheck and direct it into a retirement account. What becomes trickier is the amount we should be saving and how we should best invest it.
Perhaps even trickier is the question of what happens once we enter retirement? We've been saving money our entire lives. How do we figure out how to spend it? In theory, we know what's needed-rely on a combination of personal savings, Social Security, and if we have one, a pension.
Put another way, we move from a period defined by retirement planning to one concerned with retirement income planning.
Over the years, we've had many clients reach out to us as they recognize that the seemingly simple concept of relying on savings really isn't so simple.
At this juncture, I could stuff this newsletter with facts and statistics and what-if scenarios, overwhelming both the capacity of this newsletter and your ability to absorb it all!
Instead, I want to provide a high-level overview of two key components of retirement income planning.
(But let me emphasize-I would be delighted to answer any specific questions you may have. I am simply an email or phone call away).
Two key aspects
A survey a few years ago by the American Institute of CPAs revealed that two prime retirement income planning concerns are (1) running out of money and (2) how to more efficiently and effectively tap into assets.
That shouldn't be a surprise. "How much money do I have to live on each month?" is a common question. And, "Which accounts and in what amounts should I pull funds from?" comes up often.
Let's start with the first question. Sources of income during retirement may include Social Security, assets, earnings from part-time work, earnings from an annuity, and a pension.
Social Security, a pension, and the annuity are reasonably stable. And Social Security adjusts for inflation (for the most part). However, Social Security is not enough for most people to live on, and a lifetime of savings plays a key role in filling that gap.
Some of you are in a position to live off interest and dividends, only withdrawing principal for special needs. Many, however, must rely on carefully meting out and using much of their lifetime savings.
One approach is to employ what's called a "sustainable withdrawal rate." One common method is called the 4% rule, which some of you may have heard of.
Simply stated: Withdraw 4% each year from your savings, an amount you may decide to keep constant or increase to keep pace with inflation.
This was once a helpful rule of thumb, but low interest rates have made it less than ideal for today's retirees.
Let's look at another scenario. We can always increase the annual withdrawal rate, taking out what we need; however, if we raise it too high, there is the risk of running low or running completely out of savings.
Instead, a withdrawal rate should be based on your time horizon, asset allocation, flexibility (to turn spending on and off) and confidence level.
Questions we should consider include:
- How many years do you want to plan for?
- What asset mix (how much risk) are you comfortable with?
- What level of confidence do you want to have that your money will last?
A lower withdrawal rate will increase the odds the portfolio will last through your retirement years- that's intuitive. But it also means less discretionary income to spend in retirement.
This dilemma also illustrates the need to keep an eye on capital appreciation, especially in today's low-rate environment. It's why I'm likely to recommend that even in retirement your portfolio includes at least some mix of stocks.
Of course, flexibility and ongoing monitoring are critical. This isn't a "set and forget" situation. Adjustments can be made based on your personal situation. So, it's important we monitor and modify as necessary. And finally, you want to try to maximize your Social Security strategy, especially if you're married. A combination of delaying Social Security for one spouse while collecting earlier for the other can often maximize the funds available to a couple through the program.
Let's move to the next question-withdrawal order. Which accounts should you tap first if your goal is to maximize spending during your lifetime?
- Let's start with the required minimum distribution from tax-deferred accounts such as IRAs. At 70 ½ years old, the IRS requires that you take a minimum distribution each year. Miss it and you'll pay a big penalty. So this is a must.
- Taxable (or tax-free) interest, dividends, and capital gains distributions may be the next best source of income.
If additional funds are needed, your anticipated future tax bracket comes into play. Let me explain.
If we expect a higher marginal tax bracket in the future, withdrawing from the traditional IRA today may be the most advantageous choice. But be careful the distribution doesn't push you into a higher tax bracket in the year you take it.
If you anticipate a lower tax bracket down the road, a Roth IRA may be the best option for today's income needs. If cash is still needed or desired, then look to a traditional IRA (outside of your RMD).
However, there is one big advantage to leaving the Roth alone. You continue to take advantage of the tax-free umbrella the Roth provides. Or, you can hold on to the Roth for those inevitable unexpected expenses.
Moreover, the Roth can be used as an estate planning vehicle because heirs may be able to sidestep federal taxes when withdrawing from it. That's why I always recommend some sort of Roth savings for my younger clients (there's an income limit for contributing to Roth IRAs). And contributing to a Roth 401(k) is almost always a no-brainer.
These are just a couple of ideas designed to provide you with the proper framework as you enter or gear up for retirement. It is a broad overview that's designed to shed light on a situation that's unfamiliar to many retirees.
Each situation is unique, which means there are many other aspects of retirement income planning that could be useful for your specific situation.
My door is always open
As I have stressed, I'm always happy to answer any questions or provide a more comprehensive review tailored to your needs. But as always, when it comes to tax matters, consult with your own tax advisor.