For most of those preparing for retirement, building up the “nest egg” so it can provide enough income for a satisfying retirement lifestyle is top-of-mind. And certainly, as financial advisors, we spend a lot of time preaching the “gospel of saving,” encouraging clients to maximize contributions to tax-advantaged accounts like IRAs, 401(k)s, 403(b)s, and all the rest, along with building up taxable portfolios and positioning them for long-term growth. After all, retirement for most is supposed to be the time of life when we’re free from the daily grind, spending time doing what we want rather than what is required by an employer or for running a business. And to do that, we know that we’ll need a reliable source of cash flow to replace the paycheck or salary we’re no longer drawing.
In other words, during retirement as during the rest of life, adequate cash flow is crucial to maintaining a stable financial situation. But good cash flow planning in retirement is about more than sheer quantity. Instead, retirement cash flow planning should also include planning for tax efficiency, in order to make that nest egg stretch as far as possible. And for those building multigenerational financial legacies, insulating the estate from taxes as much as possible is vital for preserving and passing on sustains your families and communities for generations to come.
Retirement Income Withdrawal Strategy
Consider: the average American is expected to live between 20 and 22 years past their 65th birthday, according to the Social Security Administration. In fact, about a fourth of those age 65 today can expect to live past age 90, and about 10% will live past 95. In other words, many of us will live 30 years or more in retirement. And as time goes on, average life spans may be expected to increase. This means that we should be giving careful thought to the best ways to extend our retirement income streams as much as we can, while also paying
the least possible in taxes, including the portion of Social Security income that is subject to taxation. Retirement income withdrawal strategies should consider your tax bracket in retirement, leveraging both taxable and non-taxable sources of income, along with the growth and volatility characteristics of assets in all accounts.
Taxation and Retirement Cash Flow
Traditionally, the conventional advice has been to spend down taxable accounts first (regular investment accounts), then tap tax-deferred sources (traditional retirement accounts like IRAs, 401(k)s, or 403(b)s funded with pre-tax dollars), and finally, to utilize sources of tax-free income (such as Roth retirement accounts, which are funded with after-tax dollars, or tax-free income from tax-exempt bonds or bond funds). This is a pretty easy concept to grasp, and it does offer the advantage of allowing tax-deferred and tax-free sources to grow and compound without the drag of taxation for as long as possible.
Of course, income generated from regular investment accounts is taxable, either as ordinary income (including non-qualified dividends and short-term capital gains), qualified dividends, or long-term capital gains (LTCG); the latter two may be taxed at a rate below the taxpayer’s marginal rate. Income from tax-deferred accounts (like traditional 401(k)s, 403(b)s, and IRAs) is also taxed as ordinary income when the funds are withdrawn from the account. Qualified distributions from Roth accounts are not taxed.
On the other hand, the conventional wisdom may overlook a couple of important factors for retirement income: the effect of required minimum distributions (RMDs) and the impact on the taxation of Social Security income. Keep in mind that under current law, the first $32,000 of Social Security income for a married couple filing jointly is not taxed. From $32,001–44,000, 50% of it is taxable. Above $44,000, 85% of Social Security income is taxable. This is why a smart retirement cash flow strategy takes into consideration the amount and character of taxable income being used each year.
Next, don’t forget that balances in tax-deferred accounts like traditional IRAs can’t be left there indefinitely; by age 75 at the latest, taxpayers are required to start taking RMDs from these accounts. As RMDs add to the taxpayer’s ordinary income, “bracket creep” can sometimes become a problem.
Finally, remember that the main goal for most retirees is to avoid outliving their money. For others, an auxiliary goal might be to leave as much of the estate as possible for their heirs. For these reasons, some retirees may benefit from another retirement cash flow strategy that can both result in a lower tax bill during retirement and potentially preserve more of the estate for the next generation.
A More Tax-Efficient Income Plan for Retirement?
Some retirees could benefit from a different cash flow method than the one described above. Rather than allowing tax-deferred accounts to continue accumulating until taxable sources are exhausted, it may make sense for some retirees to draw some income from these accounts earlier in retirement, paying tax on them as ordinary income. Among other things, this can have the effect of “spreading out” the tax burden on the deferred amounts over a longer span and also potentially reducing the size of the RMDs required in later years. Depending on how much income other than Social Security is available to the taxpayer, this may also keep more of the taxpayer’s Social Security income from being subject to tax. It also continues the benefit of delaying the use of Roth accounts, creating the possibility for a longer stream of tax-free income in the later years of retirement.
By “biting the bullet” a little earlier in retirement and taking measured distributions from tax-deferred sources, many retirees may be able to reduce the amount of taxes paid over their retired lifetimes and potentially conserve more tax-free or tax-advantaged assets for the benefit of their heirs. Of course, any strategy should be carefully discussed with your financial and tax advisors, taking into consideration the specifics of your situation.
The Planning Center knows that securing adequate cash flow in retirement is a primary goal for most retirees and those approaching retirement. We also understand the importance of tax planning, both for current income and for preserving more of your estate for future generations. If you need help creating a customized plan for retirement cash flow, we can provide professional, fiduciary guidance. Please let us know how we can assist.
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