How to Maximize Your Retirement Income
You've spent your working life tucking money away into various retirement savings accounts. Now the day has come when you're finally ready to retire and start taking money out of those accounts instead of putting it in. You can kick back, relax, and enjoy the fruits of your labor.Or can you?
Staying funded throughout retirement
Running out of money during retirement is a disturbingly common occurrence. A report by the Employee Benefit Research Institute (EBRI) indicates that 81% of baby boomers in the lowest income quartile, and 38% in the second income quartile, will run out of money by the time they're 20 years into retirement. (I don't know about you, but I'm hoping my own retirement lasts at least that long.)
Obviously, saving more money before retiring is a big part of ensuring that you don't run out. How you choose to manage your money during retirement can also have a major impact on how long your capital will last.
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Potential tax scenarios
Income during retirement typically falls into one of three categories: taxed, tax deferred, and untaxed. Taxed income is income that you pay taxes on right away or each year, such as wages from a part-time job. Tax-deferred income comes from tax-deferred accounts, such as traditional IRAs and 401(k)s. Income from these accounts is taxed only when you take it out of the account. Finally, untaxed income is not taxed at all, typically because you've already paid the taxes on that money. A Roth account is a common example.
Investments held in a standard brokerage account, as opposed to a retirement account, are special cases with regards to taxation. Any dividends you receive will be taxed as ordinary income. If you sell investments at a profit, assuming you've held them for more than one year, you'll be taxed at the long-term capital gains rate, which is significantly lower than the income tax rate.
In fact, if your income puts you in the 15% tax bracket or lower, you'll pay no long-term capital gains tax at all. This means that this income will fall into the untaxed category. And of course, selling investments at a loss is tax free.
Get income from multiple sources
Retirees will usually have income from multiple sources. A typical retiree might have Social Security benefits, a tax-deferred retirement account, a standard bank savings account, and an investment brokerage account. If you draw income from these different types of accounts in such a way as to maximize your tax benefits, you can make the same amount of capital stretch a lot farther.
For example, Social Security benefits are taxed based on how much taxable income you have for the year. (Nontaxable interest is also included in this calculation.) Therefore, it makes sense to keep your taxable income under the Social Security taxation threshold, and draw the rest of the income you need from untaxed sources. Staying under this threshold will also keep your tax bracket low enough to put you at the 0% long-term capital gains rate, so you can safely sell off appreciated investments for tax-free income.
Maximizing tax-deferred savings
Many financial advisors recommend delaying distributions from tax-deferred accounts as long as possible, reasoning that, while money is sitting in the IRA or 401(k), it continues to grow tax free. Thus, the longer you leave it alone, the more money you'll eventually have.
However, starting at age 70-1/2, you'll have to take required minimum distributions from these accounts every year. The required minimum distribution is based, in part, on how much money is in the account, so if you take money from these tax-deferred accounts before age 70-1/2, your required minimum distributions will be smaller. This can end up saving you more money on taxes in the long term. And if you start taking 401(k) distributions before you claim your Social Security benefits, you won't have to worry about the distributions making your benefits taxable, either.
Juggling distributions from different types of accounts can get extremely complicated, since the best strategy will vary depending on your income needs, your overall life situation, and what you want to do for your heirs. Your best bet is to consult a financial advisor with experience in this area. Not every financial advisor is familiar with the needs of retirees, so be sure to ask for references, or talk with friends or family members who are also in retirement to see if they can recommend someone.
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