Having Income in Retirement Means Planning Now
When developing a retirement plan, generating income is an important consideration. It can be scary to think about giving up a paycheck and trusting your assets will be able to fund the rest of your life, or perhaps beyond. Knowing your investments have the ability to provide enough income to cover your expenses—or a portion of your expenses if you have a pension, Social Security, etc.—is key to keeping you from outliving your retirement savings.
A Rounded Approach to Retirement Income
However, there is more to retirement planning than just looking for how to generate the most income, or even match a typical amount of retirement income. It’s important to take a holistic approach. Consider what you want from your retirement, how you manage your finances, and the types of investments available to help you reach your goals.
Define Your Retirement Goals
Planning your retirement without first defining your retirement goals is an approach that can easily backfire. Many investors simply seek the highest returns, assuming that by amassing as much as possible, they’ll be able to figure out what they want to do in retirement. Unfortunately, there can be some pitfalls to this approach—such as taking unnecessary risk or chasing “hot” investments—which can be counterproductive in the long run.
Retirement Goals Drive Investing Strategy
Different goals require different ideas and strategies. Some investors want to maintain their current lifestyle throughout their sunset years. Others may want to leave a legacy, which requires a plan that can produce income well past retirement’s end. Defining what you want is the first step in being able to estimate an appropriate cost of living, which we believe is necessary when determining how much retirement income you need.
Understand Your Spending
Most investors require retirement income to cover at least a portion of their expenses. Understanding how much you spend is crucial to making sound financial decisions as you prepare for retirement, as it can help ensure a smooth transition from receiving a paycheck to relying more heavily on your nest egg.
Estimate Your Expenses
To help understand your expenses, we first recommend outlining your current costs of living—for example:
- Your monthly grocery bill
- Your monthly energy and utilities bills
- Your debts (car loans, credit cards, mortgages)
- Your tax liabilities
- Your insurance and medical costs
- Discretionary spending (meals out, travel, etc.)
Remember, Expenses Can Change
Next, estimate how your costs may change immediately once you retire. For example, if you’re no longer commuting to work, you may spend less on gas. But now that you have more free time, you might spend more on discretionary items like travel. It can be helpful to look at expenses again a few months after you’ve retired to see how your estimates matched and whether any adjustments are necessary.
In an ideal world, you should have sufficient income in retirement to cover your expenses with some room to spare. That way, it could be easier to treat yourself to some of retirement’s non-essential rewards—fine wines, a boat, exotic vacations, a classic automobile or whatever else you’re interested in—while continuing to see your funds grow. However, it’s wise to continue checking your expenses relative to your investment plan so you can remain on track to achieve your long-term goals.
Anticipate Change
As the great Heraclitus said, “everything changes but change itself.”
Retirement is a big adjustment and can look very different for everybody. Retirement income planning should be flexible enough to anticipate potential changes in spending and lifestyle. Many factors can affect your retirement income, but there are some key items to consider:
Retirement Income Considerations
Inflation
Ignoring inflation’s potential to erode spending power is one of the most common mistakes investors make. As prices increase, retirement income must also increase if you want to maintain or grow your purchasing power over time. Inflation affects all forms of savings, especially investments that provide fixed income streams.
Increased Medical Costs
As we age, our bodies are often more prone to injury and illness. So, it is reasonable for retirees to assume they will face more unplanned medical expenses more often as time goes on. Historically, medical costs have experienced higher inflation than other categories, so it’s important to plan ahead. Additionally, many underestimate the burdening costs of long-term care, which can quickly drain retirement savings if you aren’t prepared.
Some investments, like bonds, are heavily influenced by changing interest rates. If you are relying on interest-rate-sensitive income streams and interest rates fall, then you may find it difficult to secure the same level of income when you need to replace maturing securities.
Changing Interest Rates
Some investments, like bonds, are heavily influenced by changing interest rates. If you are relying on income streams tied to interest rates and interest rates fall, then you may find it difficult to secure the same level of income when you need to replace maturing securities.
You should conduct a review of your expenses at least once a year—or if a material change in circumstance like a health problem requires you to.
Investor's Guide to a Comfortable Retirement
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How You Save Impacts How You Can Spend
The type of accounts you use to save can have big impacts on your retirement income strategy. This is because various retirement savings accounts have different tax implications. Depending on your time horizon, cash flow needs and other factors impacting your tax situation, you may want to consider adjusting your strategy to better align with your retirement income goals.
Tax-Deferred Accounts
Funds deposited in a tax-deferred account go in pre-tax—meaning they aren’t taxed when contributed. The most common types of tax-deferred retirement accounts are traditional 401(k) and traditional individual retirement accounts (IRA). Any earnings on your contributions grow tax-deferred. However, because no tax was taken out initially, there are tax implications when you make a withdrawal.
Withdrawn funds are subject to ordinary income taxes. If an individual chooses to access their funds before they turn 59½, they will pay a 10% penalty in addition to the income taxes, though there are some exceptions to this.1
Roth Accounts
Investors can also open an after-tax account, the most common being the Roth 401(k) and Roth IRA. Funds deposited in these accounts are post-tax—meaning you pay ordinary income tax on any funds prior to contribution. Because the tax is paid up front, account holders don’t pay taxes on withdrawals after the age of 59½. The 10% penalty still applies for early withdrawals, similar to tax-deferred accounts.2
Which Approach Is Better?
Unfortunately, there is no right answer when deciding between these account types. The “right answer” is only seen in hindsight and is highly dependent on what your view of future taxes is. If you think your tax rate will be higher in the future, a Roth approach may make sense. If you think your future tax rate will be lower—due to either tax regulation or a change in your income requirements—then a tax-deferred approach may make sense.
There are also limitations on what you can contribute to these accounts. Not every employer 401(k) plan allows for Roth accounts. Similarly, there are income limitations associated with contributing to a Roth IRA. Each situation is different—consult a tax professional to come up with a retirement savings strategy that’s right for you.
Required Minimum Distributions (RMDs)
When considering individual retirement accounts, you should factor in required minimum distributions (RMDs), which are the minimum amounts you must withdraw each year. Generally, you need to begin taking RMD withdrawals when you reach age 72. If you reach age 72 after December 31, 2022, you can wait until you turn 73. If you don’t withdraw a RMD, don’t withdraw the full amount, or don’t withdraw the RMD by the applicable deadline, you’ll likely face a 50% tax on the required amount you didn’t withdraw. RMDs on Roth IRAs aren’t required until the death of the account owner.3
This is an important factor to consider because it may have implications on what accounts you use to generate your income. Again, there are many complexities around both how these RMDs are calculated and what accounts they apply to, which can make it beneficial to work with both a professional tax advisor and money manager capable of guiding you through them.
The Taxman Cometh
Benjamin Franklin said, “In this world nothing can be said to be certain, except death and taxes.”
While there are approaches to minimizing taxes, the government will collect their tax at some point. When formulating a plan for retirement income, you should always remember to factor in the tax that will need to be paid. You may be underestimating your retirement income needs if you aren’t factoring in the tax implications of your approach. Consulting a tax expert can help.
Choose the Right Asset Allocation
Similar to how different account types can impact retirement income, the types of investments you hold can impact your funds during retirement because they each have their own benefits and risks. We believe your asset allocation (mix of stocks, bonds, cash and other securities) is one of the most important choices an investor can make. Having the right asset allocation may ultimately make the difference between having the income you need to serve your retirement goals and running out when you need it most.
Stocks and Bonds
It is important to remember all asset classes carry some risks, but these risks come with trade-offs. For example, stocks are prone to short-term volatility, but have historically provided higher growth (capital appreciation) over long time periods than any other similarly liquid asset.
Bonds, alternatively, have shown lower growth but tend to be less volatile in the short-term. But, this does not mean that they are risk-free. There is usually some risk that the bond issuer will not repay you, or that interest rates will rise and thereby depress a bond’s value in the market.
Bonds Have Risks, Too
Perhaps more significantly, if you’re a long-term investor, holding too much of your portfolio in bonds can leave you at risk for not having enough growth to reach your long-term goals. While they can be very useful for generating income, they may be less useful in helping your investment portfolio keep pace with rising costs of living.
Annuities
If you’re approaching or in retirement, you may have had a salesperson try to get you to purchase an annuity at some point. While lofty claims of “income for life” and guarantees of “safe investment” can make them attractive for investors that need income in retirement, annuities come with some distinct disadvantages.
They tend to be expensive and complicated forms of longevity insurance, with high fee burdens that can limit their usefulness. Additionally, the income-generating goals of annuities can usually be accomplished through other products for much lower costs. In our experience, there is often a disconnect between what people assume their annuity provides (like “protection from loss”) and how their annuity actually works.
A Balanced Approach
In the end, getting asset allocation right is about balancing risk, growth potential and income generation to provide yourself with a plan that’s both flexible and sustainable for your situation. For investors with longer time horizons, this may mean enduring short-term volatility for long-term gains. Many investors don’t fully have a grasp on what approach is best for them. The guidance of a professional investment adviser in addressing these intricacies can help.
Retirement Income Planning with Fisher Investments
Whether you are already in your retirement or are considering the investment options that will get you there, contact us today.
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1IRC §72
2Ibid.
3IRC §4974