I’ve come late to retirement income planning. Now I find myself ten years from when I’d like to retire (although not quite at the R Minus Ten milestone), with a mish-mash of accounts. I have an IRA account, a standard brokerage account, cash savings, and Social Security benefits. My wife has an IRA account, Social Security benefits, and potentially a pension from her work if she stays there long enough. My challenge is to fashion all of this into some sort of income strategy.
My Retirement Income Goal–Fingers Crossed
Don’t get me wrong. I’m grateful that I have resources to work with for retirement. But if I’d thought about this earlier, by now I’d probably have a clearer and more efficient approach.
My wife and I want to stop working before our full retirement age for IRA required minimum distributions and maximum Social Security benefits. Ideally, we need some income to cover the time between stopping earning an wage and when we start taking money from IRAs and Social Security. With planning and luck, that will be roughly a five-year span.
There are calculators out there for this sort of retirement income planning. (Predictably, I built myself a spreadsheet for modeling this.) But those are more aimed for people like me who are close to retirement. For you, I’d like to talk strategy for people on their way to R-10. Things you need to take into consideration include your age, taxes, and the opportunity for money to grow.
Picturing Your Retirement Income Planning Options
There’s a lot to wade through here. You’re going to get some generalization in the post, for the sake of strategic thinking. We can dive into details in later posts. Before we take the plunge, maybe the following chart would make it easier for you to picture your retirement income planning options:
Retirement, Withdrawal Ages, and the Opportunity for Growth
It’s good to let your money grow as long as possible.
As we know, compounding is a powerful force for growing your retirement. Ideally, let things compound as long as possible. Because my IRA money can compound, I want to leave it alone as long as I can. I could start taking money out of my IRA at age 59 1/2. In the best case scenario, I don’t touch it until 70. At 70 1/2, I must start taking at least minimum annual distributions from my IRA.
(Who comes up with these ‘and a half’ age rules? I feel like a six-year-old kid writing this.)
Every month that you wait to take Social Security, your benefit rises. It’s incremental growth instead of compounding, but it’s worth pursuing. I’d like to postpone my Social Security until I’m 70. Waiting until 70 gives me the most benefit per month. (There’s another school of thought that says take Social Security as soon as possible. You get less per month, but for more months. The break-even point is around 80 years of age.)
My wife’s pension increases the longer she works at her job. Again, it’s incremental growth, but I’ll take it. She is fairly new with this particular employer, so her pension benefit won’t be much. Also, it won’t grow once she’s no longer working for the company.
Retirement Income Planning and Taxes
When it comes to taxes, retirement investment options come in three flavors: taxed, tax-deferred, and tax-free. You need to make trade-offs about paying taxes now versus later, and about having access to your money versus tying it up.
Taxed investments include stocks, most bonds, and other vanilla investment options that you hold in a standard brokerage account. You buy these investments with post-tax dollars and pay capital gains taxes when you sell them. These are not great options for tax efficiency. However, they don’t impose the age and time restrictions as tax-deferred and tax-free accounts. You can buy and sell these whenever you want. Also, some portion of Social Security is taxed, depending on your income.
Tax-deferred investments include IRA, 401(k) and 403(b) accounts. These accounts give you the benefit of avoiding taxes today. You buy investments with pre-tax dollars and don’t pay taxes on investments you sell in those accounts as long as the proceeds stay in the account. That lowers your income tax bill today and postpones taxes until you retire and make withdrawals.
There are downsides to tax-deferred investments. One, once your money goes in, you can’t take it out until you’re at least 59 1/2 unless you pay a hefty penalty. Two, depending on your tax-deferred plan, you may have limited choices about how you invest that money. Three, in the end, you still have to pay taxes.
Tax-free investments include Roth IRA and Roth 401(k) plans, and some government bonds. You buy these investments with post-tax dollars, but then pay no taxes in retirement. Roth IRAs also have fewer restrictions about early withdrawals.
Taxes and the Time Value of Money
Taxes can be a big deal in retirement. Consider a $1 million IRA account. If you expect to pay 20 percent tax rate in retirement, that’s $200,000 of your IRA going to the government instead of you. Sure, compounding earned most of that money anyway, but that’s still a bite.
Remembering that there’s a time value to money, you need to ask yourself two questions about retirement investments and taxes:
- Can I afford the taxes today? If you can, then maybe you should buy tax-free investments. You could be really happy you did that for your future self.
- What will be my tax rate in retirement? If you think your tax rate in retirement will be significantly lower than now, it might make sense to purchase tax-deferred investments.
My Picture, Still Hazy
Given compounding, taxes, age limits, and withdrawal requirements, here’s the order I’m currently considering drawing on assets in retirement:
- Spend down cash (assuming I can save enough now to start living off of in ten years)
- Sell off assets in my regular brokerage account
- Start taking social security and pension benefits
- Take IRA withdrawals
You might ask why I plan on liquidating my brokerage account early in the process if it has the chance to compound. There are a few reasons. One, it’s not that much, so the incremental growth of Social Security seems like a more significant opportunity than the compounding growth of my brokerage account. Two, the incremental growth is guaranteed, while compounding is at the whims of the market. And three, maximizing my Social Security also maximizes my wife’s Social Security survivor’s benefit, so that’s double the incremental growth.
If there’s a single right answer in retirement income planning, it’s hard to find. I hope this strategy session has helped you understand your options and clarify your goals. Remember, your answer to retirement income planning might change over the years as your life progresses. But starting with a plan that changes later is much better than living with no plan at all.
Got questions? Share them below.
(Image courtesy of Pixabay)