How to Generate Income in Retirement
March 15, 2023
When saving for retirement, your primary focus may be to invest as much as possible so you’ll have a sizable nest egg once you stop working. As retirement draws near, though, you’ll want to begin considering how you’ll take withdrawals from your investments. When you’re no longer working, you’ll need to make sure your retirement income will enable you to maintain the lifestyle you want and need.
Given retirees generally don’t have the expenses associated with providing for children, maintaining a career, or paying college tuition, it’s been a general rule that retirement expenses will account for roughly 80% of what your expenses were in your earlier life. If you are within a few years of retirement, you can expect your retirement expenses to be the same as they are now. If you want to travel often, be generous to children and grandchildren, or even dine out regularly so you don’t have to cook most nights, you might find that your monthly expenses in retirement could even be higher. But it’s better to develop, with the support of a financial professional, your own likely budget.
It’s best not to wait too long to start planning your retirement income. Even as investors reach their late 40s and early 50s, it may prove beneficial to begin considering how to draw on various sources of income in retirement. That early planning will guide not only how much you should save, but also how you might diversify your investments. Following are examples of the most common sources of income for retirees, with considerations to keep in mind about how each could be handled.
Employer-Sponsored Retirement Plans
Workplace retirement benefits come in two primary forms:
Defined Benefit Plans
These are the traditional pensions that don’t require you to contribute any of your annual income to accumulate benefits. The employer will provide a pension benefit as part of your overall compensation. These plans were once mainstays, but they’re offered less often today by private companies, although union workers and public employees, like teachers, police officers and firefighters may still have traditional pensions as part of their overall retirement benefits package.
The amount of the benefit received at retirement generally depends on your income during your working years and your years of service. Once you retire, you will have two options to receive the benefits. You may be able to opt for a lump sum, so that you receive at one time the overall value of your accumulated benefits. You can then invest it as you wish, and people will typically rollover the amount into an Individual Retirement Account (IRA).
You can also take the benefits in the form of annuity payments. With this option, you can receive a monthly benefit for the rest of your life, or that of a spouse who might outlive you, or for a set period, like 10 years. Generally, the shorter the period, the higher the payout. Opting for a 10-year “period-certain” payout may provide a higher monthly benefit if your life expectancy is more than 10 years, but the payment will stop at the end of the 10 years. The other options may provide a lower monthly benefit, but you will receive dependable monthly income for the rest of your life or for the duration of a surviving partner’s life. You will have to weigh whether a maximum payout or the security of a lifetime benefit matters more to you.
Defined Contribution Plans
With these plans, you contribute part of your income to your plan account, and employers may match your contribution each year, up to a certain percentage of your salary. For example, companies may match 100% of the contributions you make each year, up to 3% of your salary. You can contribute amounts beyond the match, up to an annual dollar limit. The limit on employees’ personal contributions to 401(k) plans in 2023 is $22,500. People age 50 and over can make additional “catch-up contributions” of $7,500 annually. Contributions to a 401(k) can be made on a pre-tax basis, or your plan may allow for Roth contributions which are made with after tax dollars. The rules for the 457 and 403(b) defined contribution plans offered to non-profit and government employees are similar to those for 401(k) plans.
Each plan participant will select investments for their savings from a menu their employer’s plan offers. The amount you accumulate will then depend on the performance of those investments, as well as the amount you save each year. Unlike defined benefit plans, there is no guaranteed benefit.
When you’re ready to retire, you may be able to keep your savings in the plan, but typically people roll over their plan savings to an Individual Retirement Account (IRA). With this option, all the tax benefits of your 401(k) savings will be maintained. You will pay taxes only on the withdrawals you make each year, while the money that remains in the IRA can continue to grow with no annual taxes on the earnings you realize.
You can also convert your pre-tax 401(k) money to a Roth IRA. With this option, you would pay taxes on the full amount you convert to a Roth IRA, but future withdrawals from the account will be tax free after five years. If you withdrew from your account over a period of many years, you could potentially save thousands in taxes. A financial professional can take your personal financial and tax circumstances into account to help you determine whether a Roth IRA conversion might be beneficial for you.
With your money in either type of IRA, you can determine how much you want to withdraw each year to supplement your income. Financial advisors use the rule of thumb that it’s generally best to withdraw no more than 3% to 4% of your total account value annually. Withdrawing more than that amount could deplete your account before you die.
With some funds and accounts, you may be able to establish a Systematic Withdrawal Plan that will enable you to withdraw a set percentage or specific dollar amount each year. Given the volatility of the financial markets, your account value will likely fluctuate each year. With a percentage-based monthly withdrawal, like 1/12th of 3%, your monthly payment will vary. In up markets, your monthly payment will be more, and in down markets it will be less. If you can live with those fluctuations and still meet your expenses, the percentage-based withdrawals may enable your savings to last longer. Taking out a set amount, like $5,000 a month, could tap into your principal at a faster rate, particularly if you have the misfortune of experiencing a prolonged down market during the early years of your retirement.
Remember, as well, that with money held in a 401(k) plan or a traditional IRA, you will have to take Required Minimum Distributions (RMDs) once you hit a certain age. The starting age for RMDs used to be 70½, but legislation passed in 2019 raised it to age 72. Additional legislation passed at the end of 2022 raised it even further. People turning age 72 after 2022 won’t have to begin RMDs until age 73. A decade from now, the age for starting RMDs will be even higher. Those turning age 74 in 2032 or after won’t have to begin these required distributions until age 75. It’s important to remember that you can be subject to a substantial monetary penalty if you don’t take these distributions when required to do so.
Social Security Benefits
If you’re a U.S. citizen who had earned income between the ages of 21 and 62, you can qualify for Social Security benefits. Full benefits used to be offered at age 65, but the age has been increased. Those born between 1943 and 1954 must wait until age 66, and there is an increasing scale of months tacked on for those born from 1955 to 1959. For example, those born in 1957 have to wait until age 66 and 6 months. Anyone born in 1960 or after is not eligible for full benefits until age 67. Your benefit amount will depend on the years you worked and the amounts you earned. You can contact the Social Security Administration to receive an estimate of what your benefits will be.
Even with the higher age requirement for full benefits, anyone eligible for Social Security can still take early benefits at age 62, although your benefits will be reduced. You’ll also receive a lower early benefit if you have additional income, generally from a job. In 2023, your Social Security benefits will be reduced by $1 for every $2 you earn each year over $21,240. Income drawn from a retirement plan doesn’t have to apply toward this threshold. Once you reach your relevant age for full Social Security benefits, you can have any amount of earned income without losing any benefits. At any time, your Social Security benefits may be taxed if your total income surpasses certain levels.
If you don’t need the Social Security benefit at your full retirement age, you can delay benefits up until age 70 and then receive a higher benefit. Someone with a full retirement age of 66, for example, could receive a monthly payment that was as much as 32% higher if they waited until age 70 to begin benefits. A financial professional can help you weigh all the cost/benefit trade-offs of the options available to you for receiving Social Security on an early, on-time or delayed basis.
Personal Savings that Can Generate Income
Outside the income you can expect to receive from Social Security and your employer-provided retirement plans, you can also use personal accounts to build retirement savings. For example, you can invest in individual stocks and bonds or diversified portfolios of stocks and bonds in mutual funds or Exchange-Traded Funds (ETFs). Here’s an overview of some of the investments you may want to consider for your personal accounts:
|Stocks and Equities|
|REITs (Real Estate Investment Trusts)|
In addition to various asset classes, you might also consider different investment vehicles. Annuities, for example, can provide set monthly payments in the same way regular payouts from traditional pensions do. The fees on annuities can be high, but the predictability they can bring to at least a portion of your retirement income could make their cost worthwhile. Your financial advisor can help you weigh the pros and cons of including annuities in your retirement income plan.
If you have cash value life insurance, like whole life, you may also be able to use the policy to supplement your retirement income. Talk to your advisors about the pros and cons of establishing a life insurance retirement plan (LIRP) from your policy.
Build a Tax-Diversified Strategy
If you invest your retirement savings exclusively in a defined contribution plan or traditional IRA, all your withdrawals in retirement will be treated as ordinary income, which is generally taxed at the highest rate.
In the same way you diversify your holdings to own different types of investments, you may want to diversify the way your retirement savings will be taxed. Diversifying how your savings is taxed could help you realize a higher level of after-tax income. Here are a few ways to diversify your savings to potentially lower your tax bill:
- Invest a portion of your retirement savings in an after-tax account – you will only owe taxes on investment income, including interest, dividends and capital gains from selling these assets. Taxes on dividends and capital gains are typically taxed at a lower rate than regular income.
- Roth IRAs – consider contributing to a Roth IRA or converting some of your tax-deferred 401(k) or IRA to a Roth. Although the amount you contribute or convert is done after taxes, all withdrawals from a Roth IRA are tax-free after five years.
- Municipal bonds – these are an investment vehicle that generate tax-free or tax-efficient income. Earnings from these bonds are generally not taxed, making them an attractive alternative to traditional bonds or investments.
Determine the Sequence of Withdrawals
If you do own a mix of investments that are taxed in different ways, you’ll have to determine which accounts to withdraw from first. The general rule, in this case, is to delay taking money from accounts that allow you to defer taxes. For example, it may be better to sell investments in an after-tax account and delay taking withdrawals from your traditional IRA to continue deferring the taxes. However, if you have most of your retirement savings in tax deferred 401(k)s and IRAs, you may want to take withdrawals from those accounts sooner to reduce your future tax liability. A financial professional can help you determine the best order of withdrawals from your accounts.
A Holistic View – And Expert Advice – Will Guide Your Planning
Examining all your potential sources of income will indicate how much you’ll need to withdraw from each account every month. With your Social Security benefits or wealth from other sources, for example, you might be able to withdraw less than 3% or 4% annually from your personal accounts and retirement savings. That option could be appealing if you’re hoping to leave an inheritance for family members. The team at Trinity Wealth Management can help you devise a savings and income strategy that will maximize the amount you have to live on, so that you can enjoy a comfortable retirement and perhaps even leave a legacy for loved ones.
The commentary on this website reflects the personal opinions, viewpoints, and analyses of the Trinity Wealth Management, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Trinity Wealth Management, LLC or performance returns of any Trinity Wealth Management, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Trinity Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
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- “How to Delay Claiming Social Security Until Age 70,” U.S. News and World Report, Sept 21, 2022