Creating Your Retirement Paycheck
Most people don’t plan on working forever, so we all know it is imperative to lay the groundwork for our financial future. Maybe you already have a diversified portfolio that you have been building over the course of your working life. The challenge many retirees face is figuring out how to generate a predictable income from the wealth they have built over the course of their lifetime. No one wants to have to live a lower quality of life—you want to be able to maintain your current lifestyle throughout retirement. This process is known as “building a retirement paycheck.”
Everyone will approach retirement with different goals, needs, resources and risk tolerance levels. It is important to take a detailed and honest inventory of each of these factors to determine how much money you will need to “pay yourself” each month or year of retirement.
Assessing Your Resources
Not everyone’s retirement paycheck will be put together in the same fashion. In fact, most “paychecks” will be crafted from a combination of some or all of the following resources:
1) Pension Plans: For many retirees, a defined benefit pension plan provided by their employer is the most predictable source of income. The issuing government or company promises to pay the retiree a certain amount over their lifetime (and often the lifetime of their spouse depending on elections made during employment). The retiree knows what amount to expect each month and can use it as a base to begin covering living expenses.
2) Social Security Benefits: While social security benefits might not be the majority of your retirement income, it will help to narrow the deficit between expenses and income. In some cases, retirees may need to use their social security benefits to bridge the gap between their early retirement years and the years when they must begin taking mandatory distributions from their tax-sheltered accounts such as IRAs and 401(k)s. In other cases, it may make sense to defer taking your benefit (up to age 70) to gain the extra 8% per year that social security will pay for waiting.
This decision should be based on many factors including your health, longevity, other sources of income and your personal preferences. It’s best to consult with a Certified Financial Planner™ or contact the Social Security Administration directly to ensure that you understand all of your options.
3) Investment Portfolio: For many, an investment portfolio will need to serve multiple goals and employ the appropriate strategies for reaching these goals. Because different assets have different rates of return, it is important to have the proper asset allocation for your portfolio. Your portfolio should always take into consideration your personal risk tolerance level, life expectancy, and other retirement income resources. But overall, asset allocation will be determined by your objectives for the portfolio. Will you be using it primarily to cover living expenses or to increase wealth for your heirs? With so many options available, it may be in your best interest to consult with a Certified Financial Planner™ who will ensure your portfolio is properly diversified and generating the income you need for retirement.
4) Work: Many retirees find it both mentally and financially beneficial to work during retirement. In fact, consulting has grown in popularity as a post-career choice amongst retiring professionals. Some people enjoy the social interaction and mental stimulation that working provides, while others decide to work during retirement to defer taking government benefits and avoid depleting their assets. After all, untouched assets will continue to compound over time, increasing your overall spending threshold and retirement longevity, depending on your preference and risk tolerance.
5) Stock Options and Restricted Stock:
If you have a stock plan through your employer, the decisions that you make during your pre-retirement years can directly affect when you can retire and what level of income you can enjoy in those years.
While this type of equity compensation can greatly benefit you during your working years, it is a concentrated risk in your retirement portfolio. Once you retire, your stock plan will detail when or whether vesting continues or stops. It is advisable to closely review your stock plan provisions for the rules and definitions that apply to "normal" retirement and "early" retirement (if it makes this distinction). Then choose a retirement date that maximizes the number of vested options and shares.
For stock options, it is prudent to begin a regular program of exercising options well before retirement. This prevents the need to exercise all stock options just before or at retirement. It also helps you diversify should too much of your net worth be linked to movements in your company's stock price.
6) One-time sources of income: Consider expected lump sums, such as life insurance proceeds, inheritance or net proceeds from the sale of property or a business.
7) Other Income Sources: You may have other fixed or regular sources of income, such as rental income, deferred compensation, and alimony. It is important to determine when payments may cease and the tax implications of the payments.
Timing is Everything: Tax Considerations
Taxes are an inevitable cost that is incurred when creating a retirement paycheck. To increase the longevity of your portfolio, it is important to properly time your withdrawals from each account in such a way that minimizes the amount of taxes you will pay overall.
Essentially, each of your accounts will fall into one of three categories:
(1) Taxable (bank accounts or brokerage accounts)
(2) Tax-deferred (such as traditional IRAs or 401(k)s and other employer plans)
(3) Tax-free (from Roth IRAs or Roth employer plans)
It is usually best to start depleting your taxable assets before spending from tax-deferred. This has two benefits for the longevity of your portfolio: it allows your tax-sheltered accounts to continue to grow as long as possible and it decreases the amount of taxes paid.
When you withdraw from your tax-deferred accounts, you will pay ordinary income taxes on the entire amount withdrawn rather than just capital gains tax on the appreciated amount. And since ordinary income taxes are typically higher than capital gains tax, you would be paying a higher percentage of tax on your withdrawals.
The only caveat to this rule is if you can withdraw from your tax-deferred accounts at a low tax rate because either you have minimal income or increased deductions that make it more advantageous to take a withdrawal from your tax-deferred account.
Tax considerations are not only critical when making withdrawals, but also when constructing a portfolio. In order to maximize after-tax returns, it is smart to hold tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts. Knowing which assets to buy and what type of accounts to hold them in will drastically improve your retirement savings by lowering your taxable income.
Seeking A Trustworthy Guide
The reason so many people procrastinate planning for retirement is because the options seem overwhelming. Doubts creep in. Will I miss working? Will my resources last my lifetime?
We know that major life transitions like retirement bear both financial and emotional implications, which is why our team, which includes Certified Financial Planner™ professionals, Financial Transitionists®, and a CPA are here to help you navigate these new waters. We are here to remind you that retirement shouldn’t be a time fraught with worry, but rather an exciting time to enjoy life, embark on new adventures, and spend time with your loved ones. We are here to empower you to build your best financial future so that you can do all of the above (and more!) with confidence and peace of mind.
Contact us today for a complimentary "Get Acquainted" meeting. We look forward to helping you build a secure financial framework for your retirement.