Do you know where you're going to get the money you need to live on in retirement? A retirement income plan can help ensure that you won't run out of money no matter how long you live. But to get this level of certainty, you need to base your plan on the three most important income factors.
Multiple income streams
Having multiple sources of income is always a good idea, but it's especially important in retirement. If you have just one source of income, you'll be in deep trouble if something happens to it. But if you have several different income streams, losing one may be no more than an inconvenience.
Many retirees count on just two sources of income: Social Security benefits and a retirement savings account such as an IRA or 401(k). That's a good start, but two sources of income is pretty minimal. What happens if the government suddenly cuts your Social Security benefits? Or what if there's a major stock market crash and your retirement savings suddenly lose half their value?
For starters, you should diversify your retirement portfolio. At a minimum, you'll want to invest in both stocks and bonds to provide a mix of investment income sources. It's also wise to have both a traditional and a Roth IRA to draw on, as this gives you more control over your savings and your tax bill. Traditional IRA distributions are taxable, and Roth IRA distributions are not. Roth IRAs are also exempt from required minimum distributions.
Second, consider arranging one or two other sources of income besides your retirement portfolio and your Social Security benefits. For example, purchasing an annuity can give you a dependable source of income -- if you read the fine print to make sure you understand what you're buying and stick to fixed annuities -- not variable annuities. Picking up a side gig is another option, as is investing in real estate if you have sufficient funds.
For example, let's say you have retirement savings accounts that provide at least $1,500 of income per month and Social Security benefits of another $1,500 per month, and you work five hours per week after you retire to bring in an extra $1,000 per month. If your Social Security benefits were reduced by 25% ($375 per month) due to benefit cuts, you could likely arrange to work six hours per week instead of six for a while and make up the missing income quite easily.
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Distribution planning
Drawing money out of your retirement savings accounts willy nilly can lead to disaster. Your first year of retirement is an especially precarious time, as you're just learning the ropes and figuring out how much income you'll need to get by. What's more, taking too big a bite out of your savings early on makes it much harder for the remaining money to grow fast enough to keep up with your expenses. It's crucial to limit your distributions to well below your annual returns from those accounts.
Required minimum distributions (RMDs) can also throw a monkey wrench into your plans. Once you reach age 70 1/2, the IRS will require you to take a certain minimum amount out of your tax-advantaged retirement accounts. Your RMD for the year is based on your age and your balances across your traditional IRAs. If it's higher than the amount you actually need to withdraw, you could end up paying additional income taxes that you can ill afford.
A Roth IRA is an excellent tool because, as previously mentioned, these accounts are exempt from RMDs. Keeping a large percentage of your retirement savings in a Roth account can therefore reduce your RMDs and give you much more wiggle room in your account withdrawals.
For example, if your retirement savings balance is $800,000 and it's all in a traditional IRA, your first RMD (assuming you turned 70 1/2 in 2017) would be $29,197. Even if you only needed to withdraw $25,000 that year for income, you'd still have to withdraw, and pay income taxes on, the extra $4,197. For a retiree in the 25% tax bracket, that would amount to another $1,049.25 in taxes.
But if you'd instead put half your money in a Roth account, your RMD would be just $14,599 -- well under the amount you had already intended to take, so you wouldn't have extra taxes to pay.
Tax planning
Taxes are one financial concern that tends to get more complicated once you retire. That's because you no longer have an employer withholding your income taxes for you; instead, you have to calculate your own tax bill, and you'll probably have to make quarterly estimated tax payments to the IRS. Just to make things even messier, your Social Security benefits may be subject to income tax, depending on your "combined income" for the year. Combined income is the sum of your adjusted gross income, your nontaxable interest, and one-half of your Social Security benefits for the year. If your tax filing status is single, then your Social Security benefits become taxable when your combined income exceeds $25,000. For married couples filing jointly, the threshold is $32,000.
Again, Roth IRAs can be a big help because distributions from a Roth account are not taxed. So not only do you not have to pay taxes on the distribution itself, but because the distribution doesn't count as taxable income, it also reduces your odds of having to pay taxes on your Social Security benefits. Your best bet is to have both a traditional IRA and a Roth IRA and plan your distributions from each account in a way that will minimize your income taxes for the year.
For example, if your Social Security benefit is $1,500 per month and you had enough taxable income from your traditional IRA distribution to make that benefit 85% taxable, you'd owe taxes on an extra $15,300 in income (which means an additional $3,825 in taxes for someone in the 25% tax bracket). But if you have both traditional and Roth IRAs to draw from, you can arrange your distributions to keep your combined income under the Social Security taxation threshold -- saving you $3,825 in taxes, plus whatever taxes you would have paid on the income from your traditional IRA that you took from the Roth account instead.
This sounds complicated!
If all this sounds like way too much work, consider meeting with a financial planner with experience in retirement-related issues. Getting help with your first year of retirement may be all you need; in future years you can use the initial plan as a template for account withdrawals and tax planning. That will save you on advisor fees while still giving you an excellent start on your retirement finances. Just make sure your advisor addresses each of the above concerns in your plan.
