How to pay yourself in retirement: What do you do when your paycheck stops?
Life transitions in general can feel scary, but retirement brings changes that many people find challenging. The big questions we frequently hear from clients approaching retirement are: what happens when I stop getting a paycheck and how do I pay myself in retirement? Many folks have worked for a long time and done a great job of saving for their eventual retirement. During these accumulation years your financial life can feel more “automated.” You have a certain income every paycheck and can set up a regular retirement plan contribution amount and perhaps additional regular contributions to a brokerage or savings account. Your main job is to cover your budget with work income and to grow your savings and investments. Then, all of a sudden, you are being asked to flip a switch and go from saving into accounts to spending down those same accounts. How do you do this safely and effectively given your specific situation? We will outline some of the key considerations we use when making a retirement distribution plan for our clients and how to think through your specific situation. The starting place for how to pay yourself in retirement is to consider the assets and resources you have available.
The most common form of fixed income for retirees is Social Security. You can login to ssa.gov to find out your current estimated benefit at full retirement age (FRA) and other options such as delaying or taking your benefit early. Claiming your benefit before FRA creates a permanently reduced benefit amount, so it is best to avoid this if at all possible. Under current rules, you are allowed to delay claiming your benefit until age 70. For every year you delay post-FRA, your benefit increases by 8%. Social security benefits are also increased by an inflation adjustment factor every year and so will help keep up their purchasing power over time. If you are married and one spouse does not have a work history outside of the home, he or she is entitled to spousal benefits which are half of the working spouse’s benefit at FRA.
Although they are currently not as common, you may have access to a pension plan. If so, you should request an estimate of benefits at various eligible retirement ages from the plan administrator. Be aware that not all pensions include an annual cost of living adjustment and pensions that do not have this feature will lose value over time as they will not keep up with inflation.
When making a plan for paying yourself in retirement, first consider which fixed income benefits you will have access to and whether they will adjust with inflation. Determine your full fixed income benefit and if you might be able to increase it by delaying when you claim the benefit. If your total fixed income benefits cover your core retirement budget, then you are very likely to be successful in retirement. However, if like most people, your fixed income payments are not enough to cover your core retirement budget, then you will need to more carefully consider how to use your other assets when paying yourself in retirement.
One of the next most common resources that retirees have available is the value they saved into various retirement accounts. You may have saved into an employer retirement plan such as a 401k or 403b plan. You may also have accumulated value in a traditional IRA or Roth IRA account. These types of accounts have special rules when it comes to both distributions and tax treatment. We will discuss the two main types of retirement account value- pre-tax vs. Roth- and ways they can be used in retirement.
Pre-Tax or Traditional Retirement Accounts
If you have funds in a traditional 401k or traditional IRA this means that you contributed money on a pre-tax basis while you were working. These contributions will likely have grown in value over time and you will not pay any taxes on the value until you start taking distributions from the account- thus they are known as tax deferred accounts. Keep in mind that you will pay taxes on any distributions from these accounts in retirement at your ordinary income tax rate. This means that the actual value in these accounts is less than what shows on your statements as a portion will go towards paying taxes.
There are special rules around when you can take distributions from these accounts- as early as 59.5 from an IRA and 55 from a 401k. It is important to fully understand these rules as early distributions can result in a 10% penalty in addition to paying regular income taxes. If you plan to retire before age 60, be sure to consider how and which accounts you will use to pay yourself so as to avoid unwanted penalties.
However, you are not allowed to leave money in these accounts indefinitely. Eventually, you will be required to take annual distributions from these accounts also known as a Required Minimum Distributions (RMD). The current RMD age is 73 and will adjust to 75 in the year 2033. It can be helpful to estimate what your RMD value would be in today’s dollars to get a sense of whether you will need all of that income when you reach RMD age or potentially not. To do this, you can take your current account value and divide by 27.4 (this is the life factor used at RMD age 73). If you find that your RMD estimate looks like more income than you will need, consider some alternative strategies to lower your RMD and save taxes in the future. Click here to read more about some of these strategies. If your RMD amount along with your fixed income (Social Security and/or a pension) will be sufficient to cover your core spending, then you are likely on track to be successful in retirement.
Roth Retirement Accounts
You may have been able to build up some value in a Roth 401k or Roth IRA during your working years. These accounts are especially powerful as you will never pay taxes on the funds in the account as long as you follow the rules for a Roth. You are also not required to take distributions from these accounts, so you have more control over how and when you distribute the funds in retirement.
There are a couple of beneficial strategies for considering the use of your Roth account. One approach is to leave the account invested for as long as possible (given the favorable tax-free growth) and then consider the value as additional funding at your end of life for increased health care or long-term care costs. Another approach is to use the Roth funds to supplement your spending needs above your Social Security and RMD amount instead of pulling additional funds from your traditional IRA and paying taxes on them.
Taxable Brokerage Accounts
An additional source of assets that can be very helpful along with fixed income and retirement accounts is value saved into taxable brokerage accounts. These accounts do not come with favorable tax treatment- you are taxed annually on any investment income generated by the holdings. There is, however, a more favorable tax rate for qualified investment income which can include qualified dividends as well as long-term capital gains. Tax payers who have low enough overall income to stay in the 12% Federal tax bracket will not actually pay any taxes on this qualified investment income. This can make these holdings more favorable during retirement which tends to be a lower income phase of life.
These funds also allow for flexibility as there are no special restrictions on usage unlike in a 401k or IRA. Before RMD age, value in a brokerage account can be used to help cover your retirement spending while keeping your taxable income low. This may allow you to do some level of Roth conversions where you turn fully taxable IRA value into tax-free Roth IRA value. After RMD age, these accounts can be a great source of additional funding for special one-time expenses such as replacing a car or taking special trips. Pulling funding for these bigger unusual spending items from a brokerage account rather than additional money from an IRA can help reduce your tax rate- this let’s you keep more money in your account and lose less to taxes.
While we have touched quite a bit on the various types of retirement and investment accounts that can be used as part of your retirement income strategy, we have not talked about how those accounts are invested. If most of your investments have been in employer retirement accounts such as a 401k, you are probably used to a target retirement date style of fund. These funds have a mixed allocation of assets meaning they are made up of some portion of stock and some portion of bond investment. They are designed to shift in allocation over time as you get closer to your desired retirement date. Typically, they will start at something like a 90% stock/10% bond allocation and shift closer to a 60% stock/40% bond allocation by retirement. This is because the stock allocation has much greater return potential but also much higher volatility. The bond allocation is intended to generate lower returns but also be much more stable than the stock allocation. When you have a longer investment horizon, larger stock allocations allow for greater overall returns. However, as you enter a few years out from retirement, you know that you will start actually taking money from the portfolio and may wish to decrease the overall volatility of your portfolio.
As you approach retirement, it’s important to review your current level of stock vs. bond investment funds and determine if the amount of bond and cash coverage you have is a comfortable level for you. For many people, it can be helpful to have a range of 7-10 years of spending needs above your fixed income allocated to bonds and cash. This would allow you to more easily make it through a bad equity market downturn and recovery period. For example, if you estimate that you will need $30k/yr above your Social Security or other income sources in retirement, you might look to have $210-300k in bonds and cash coverage. For more specific recommendations and support in building an appropriate investment allocation, please consult with a trusted financial advisor.
A major consideration if you plan to retire before age 65 is what will your estimated healthcare costs be prior to enrollment in Medicare. Private health insurance in your late 50’s and early 60’s can be fairly expensive making this an important consideration in your retirement planning. If you have access to a Health Savings Account during your working years, one great strategy is to contribute the maximum to this account and invest the allowable balance as you would your 401k rather than spending it. This allows you to grow these specialized savings that can then be used tax-free for health care costs in retirement.
Your income in the 2 years leading up to age 65 and then forever-more post age-65 has an impact on your specific Medicare costs. If you happen to have income above certain thresholds, then you will end up paying some additional cost in premiums known as Income Related Monthly Adjustment Amounts (IRMAA). It is important to pay attention to these threshold amounts especially as you consider strategies such as Roth conversions that create taxable income. You can read more about how paying yourself in retirement affects your Medicare premiums here.
Another consideration if your retirement plan is not as strong as you want it to be is to consider some level of part-time employment in retirement. This could include a variety of options such as: a period of reduced work hours/income with your current employer, retiring as an employee but starting up some consulting work or even taking up a low stress part-time job in an area of interest. Any additional income you generate will reduce your need to draw down on your investment accounts and can help you bridge the gap between initial retirement and Social Security benefits and RMDs.
As you can see, there are many different considerations when planning for how to pay yourself in retirement. By understanding the income and assets that will be available to you, you can start the process of making a plan. We also recommend talking to a trusted financial advisor for further help in reviewing your strategy or considering more complex tax planning strategies.
Liz Alf is the Principal of Clerestory Advisors and fee-only CERTIFIED FINANCIAL PLANNERTM located in Minneapolis, MN. She is a member of the National Association of Personal Financial Advisors (NAPFA) the Fee Only Network and Wealthtender. She enjoys serving clients with on-going financial planning and investment management services.