Updated: One of the most important aspects of retirement is how to fund your retirement. Your transition from accumulating wealth to withdrawing from your nest egg can be frightening and difficult. Retirement planning is all about managing cash flow and income versus expenses.
In this article we will teach you how to determine your current and necessary income, as well as how to consider subsequent decisions like tax implications. Most retirees do not like to think about spending down their retirement savings. We at Peak Financial Planning want to remind you that it is perfectly normal to feel some anxiety as you approach retirement.
Before you start making decisions and changing your future outcomes, you need to determine your current financial situation, including sources of retirement income. This is the first step in crafting your retirement plan.
We will list the common retirement income sources that you should consider as you approach retirement. In an ideal world, you have high benefits coming from guaranteed sources, like Social Security or pensions. Following that, you would withdraw from investments to bridge any gaps that may exist between your guaranteed income and desired level of spending.
If you don't have much guaranteed income when you retire, the biggest decision you make in retirement is when to claim Social Security Benefits. Without these forms of guaranteed income, you are dependent upon Required Portfolio Income, which we call RPI. Your RPI is how much income you need to withdraw from investments to support your living expenses. You must keep in mind that your Social Security amounts depend on when you file for your income.
You can take reduced benefits at 62, wait until you're eligible to receive your full benefits—between age 66 and 67—or delay your income to qualify for a larger amount. Traditional advice tells you to wait for full benefits. In most cases this is the best decision. However, claiming earlier may be smarter for you if you have no other income to supplement your essential expenses.
The Social Security Administration has these helpful links to calculate your monthly income based on your own situation and information about filing.
You can also decide whether to claim individual values or spousal benefits. If you and your spouse both had high incomes and contributed to Social Security during your working years you will likely claim individual records. If one spouse earned significantly more than another, you can claim based on the higher earners record.
When eligible for both individual and spousal benefits, the Social Security Administration will pay the lower earning spouse based on their individual record before spousal benefits start. Think of this like a marginal income tax bracket. The first portion of your income is taxed at a lower rate, and the remaining dollars will be taxed at a higher rate. If your spousal benefits are higher than your own retirement benefit, you will receive a combination of benefits equaling the higher spouse's benefits.
COLAs Help You Outpace Inflation
There are increases in Social Security benefits each year known as cost-of-living adjustments, or COLA. This is in place to help you keep up with inflation. COLAs became an automatic yearly increase in 1975.
Keep these in mind when you account for income in your retirement plans.
Employer plans can be a highly valuable source of income in retirement. These make up some of the guaranteed income that minimizes your portfolio withdrawals.
A defined benefit plan ensures a fixed monthly payment for eligible employees, compared to defined contribution plans (like 401(k)s), where payments vary.
Some contributions will give you deductions on your tax return, deducting the contribution and creating tax deferred income. Some plans allow post-tax Roth contributions, providing tax-free income in retirement.
Employees typically need to work for a specific period before becoming eligible for defined benefits. Your payments will depend on multiple factors, often including years of employment, average salary, or highest earning years. With these plans, employers bear the responsibility for managing investments and guaranteeing specific benefit amounts.
Oftentimes your spouse is entitled to some of your pension. The typical amount is 50 percent of monthly payment, but you may be able to increase the survivor benefit. If you want to remove your spouse as a beneficiary, your spouse must sign a written consent form waiving rights to this income.
Government employees have their own set of extra rules and guidelines. For example, government employees might have to contribute using after tax dollars. Employees may be able to receive their pensions after a set period—such as 20 or 30 years—no matter how old they are.
Public employee pensions and military benefits tend to be adjusted automatically for inflation using a COLA.
Some pensions are covered by the Pension Benefit Guaranty Corporation (PBGC). The government runs this sponsor of lost and ended plans. If you lose track of your pension or your employer plan runs into problems, seek help from the PBGC. You also can search for a pension on the PBGC's website.
401(k)s, 403(b)s and 457s are the most common defined contribution plans. These come in many employers including government benefits.
You will likely get an employer match as well, up to a certain dollar amount or percentage of your contribution (because employers make mandatory contributions to meet IRS requirements).
Usually these allow you to make investment choices from a limited menu of options. This means that the investment performance is your responsibility, and the employer makes no guarantee to your account value.
Because these are majority funded by employees, you can get more of what you invest with a quicker vesting schedule. You are also often allowed to make rollovers to another defined contribution plan or IRA upon separation of service or retirement.
Make sure you take time to comparison shop. In most cases, you do not need to make a snap decision with respect to your current employer’s retirement savings plan.
Your investments can be a supplemental source of income in retirement. Required Portfolio Income is the amount you'll need to cover living expenses like groceries or housing payments. Should you have excess investments, you can consider luxury spending for your personal goals or experiences with your loved ones.
First you should create a cash reserve for emergencies, generally three to six months of your basic expenses. You want to keep this cash in an accessible account like a money market fund. If you need to dip into these savings, you will want to replenish this cash reserve as soon as possible.
Once your safety net is secured, you want to consider investment choices that suit your risk appetite and income needs. Keep in mind that fixed income investments can also supplement your spending needs. Common examples are treasury ladders or dividend portfolios. Remember to always consult trustworthy financial advisors before making any important decisions regarding investments.
As you manage your investments you need to consider the tax implications. These include under withdrawal during Required Minimum Distribution (RMD) age. As of 2024 RMD's start at age 73. This means that you must take out a minimum amount from: profit-sharing plans, 401(k) plans, 403(b) plans, 457(b) plans, traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.
The RMD can be calculated online or with your financial advisor or CPA. The penalties for under withdrawals include 25% of amount not taken, or 10% if fixed within a specific grace period.
Selling your home is a major decision that needs financial and emotional consideration. Here are some details worth mentioning. Many retirees can gain a substantial sum of money from a home sale. Despite the amount of cash to consider, this is often a last resort. Home sales can also be a byproduct of desire to experience new things in retirement.
Remember that the proceeds of your sale must go towards any remaining mortgage balances. Your home value can also fluctuate with economic conditions including interest rates and local housing market volatility.
You also need to consider what your own personal goals are. Do you want to move to a new environment and get out of your comfort zone? Do you want to leave a house for your children or spouse? Do you have backup assets to cover your living expenses?
Pros include a large lump sum of cash to either invest or put towards a new home and a capital gains deduction ($250,000 for a single person and $500,000 for a married couple. Not owning a home also means cutting expenses of maintenance and property tax.
Cons include the emotional attachment to your home and the need to look for new housing. If you decide to downsize and buy a less expensive home, you will need to consider one of two options, purchasing outright or obtaining a mortgage on the new home.
The first option carries peace of mind, but it will tie up more of your money, leaving less to generate income. On the other hand, taking out a new mortgage means you must cover the cost of the mortgage month in and month out. If you go this route, it will be extremely important to manage your money to ensure it generates enough income to pay your mortgage.
Most Americans over the age of 62 are eligible for a reverse mortgage allowing you to take cash in exchange for your built-up equity. Many companies will require you to own a larger portion of the equity in order to use these services. You can take a reverse mortgage from federally insured lenders, or private companies.
A reverse mortgage means you get paid to lower your equity over time, rather than you paying into the equity. Age, mortgage rate, and home value all contribute to the amount you are eligible for. The payments are also tax free because the payments are considered a loan. Reverse mortgages are an option for retirees who are in dire need of income, best saved when you are in dire need of income and have no plans to pass on your house to heirs. Remember once you take a reverse mortgage, your debt grows with each payment you receive. That debt must be repaid when you die, move out of the home, or sell the property.
You can take the proceeds as a single payment, a series of regular payments or a line of credit. An appealing feature of a reverse mortgage is that no income tax is due on the money you receive, because it’s a loan, not income.
One of the last resorts for retiree income is to continue working. Hopefully this is a choice made out of desire to work and feel fulfilled, rather than desperation for income. Remember that working while you are on Social Security benefits also affects your benefit amounts.
If you are under full retirement age, your benefits are reduced by 1 dollar for every 2 dollars earned over the annual limit ($22,320 in 2024). After full retirement age your benefits can't be reduced. Those earnings include any employment wages or self-employment income. Pensions, annuities, investment income, interest, and other government/military retirement pay aren't included.
If you pay social security tax you will also be contributing more to your social security record.
Determine how much income you need to live, and how much you will be earning from your stable sources. Create a budget of necessary and discretionary expenses, compared to your predicted earnings. Then plan out when you will want to claim social security benefits. All of these details will determine how early you can retire.
Retirement income is available from many sources. If your current income from predictable sources like retirement plans or social security is not enough, you have a few options. You will need to consider drawing down your retirement savings, getting a new job, or selling your home. Conduct some in depth research with financial advisors that you can trust before making a decision. That way you can avoid tax penalties and preserve your personal savings.
There is no universal answer to investment selection for retirees. You need to consider your own objectives and limitations. Investment choice depends on cash needs, time horizons, and your desires for your savings. Make sure to balance growth, income, and capital preservation.
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