How to Take Income in Retirement the Smart Way

Hello, everybody. My name is Ty Bernicke, and today I’m going to be talking to you about how to take income in retirement the smart way.

Some of the different things that I’m going to be talking about today are determining a new tax minimization plan each year and why that’s so important, why allocating and investing accordingly based on your time horizon is important.

We’re going to talk about considering taking income monthly and what that can do for you, making sure that you account for paying your taxes. And then I’m also going to be talking about enjoying your money while you can, and what that means.

Investment Buckets

If you’ve heard me talk in the past, you’ve definitely heard me talk about the different buckets that investments can fit into.

I always like to look at each investor, and we try to look at the investments that they have and classify them into one of these three buckets. There’s the tax-deferred bucket, which means money goes in on a pretax or a tax-deductible basis. It grows tax-deferred, but when you take money out of this bucket, generally 100% of that is subject to ordinary income tax.

When you contrast that to a tax-free bucket, which could include things like Roth IRAs, Roth 401(k)s, Roth 403(b) plans, or Roth 457(b) plans, you don’t get any tax deductions when you put money into this bucket. However, your money can grow income tax-free, and you’re not forced to take anything out of that bucket during your lifetime.

There can be advantages in each of the buckets depending on your unique circumstances. And then there’s a third bucket we call the non-qualified bucket. The reason we call it non-qualified is that it basically means non-retirement. So, not an IRA or a 401(k) or a Roth IRA, Roth 401(k). You don’t generally get special tax deductions when you put money into this bucket.

Whatever you put into the bucket, you can always take that basis out tax-free in the future. But whatever you’re invested in might have tax implications. You could have capital gains tax, dividend tax, or interest income tax. So, each investment works very differently with how it works in this bucket and needs to be adjusted accordingly.

Income Planning in Retirement

One of the things I always encourage people to do is think about when you retire and where you’re going to be getting income from, and how much of your income is going to have to come from investments.

Early on in retirement, your needs will probably be very different than later on in retirement, and thinking about where you’re going to get your income from in each of these buckets can help you determine how to allocate your assets in the different buckets. A lot of times, it can make sense to take a larger amount of income out of the tax-deferred bucket early on in retirement, and there’s a variety of different strategies on how to do that.

But many times, it makes sense to take money out of multiple buckets in one year to potentially keep you from going into a higher-than-necessary tax bracket. So, every year, I encourage people to look at that year’s unique circumstances, that year’s tax laws, and determine what the income plan is going to be at the beginning of the year, based on what we know your needs will be for that year.

Don’t blindly go into this saying, “This is where my income is going to come from for my buckets for the next ten years,” and stick with that plan because nine times out of ten, that’s not going to be the most tax-efficient way to do it. You have to be able to zig and zag with your unique circumstances and the changing tax laws.

Aligning Investments with Time Horizon

In addition to that, I think it’s extremely important to look at those three different buckets that we just mentioned and think about what your time horizon is for the income that you’re going to be taking out of those assets. So, if you’re going to be taking a larger amount out of the tax-deferred bucket early on, you might need to put a higher amount of short-term investments that are more conservative in that bucket to prevent yourself from having to sell something that is temporarily down in value.

So, you might not want to go 100% into growth investments or stock investments in that bucket. Because if your time horizon is short, you want to match the needs of that bucket to that time horizon.

Monthly Income Approach

Another thing that I think is helpful, at least from what we’ve witnessed over the years of helping people with retirement, is to consider taking your income from your investments on a monthly basis when you retire. Generally, when you have investments, you can decide how to take income from those various buckets I mentioned before. You can take it all in a lump sum at the beginning of the year.

You can take it all as a lump sum at the end of the year. You can take the income from that bucket monthly too. And the reason that I like and encourage people to take income from their investments monthly is because it kind of has a forced, built-in budget. I think as we’re in our working years, we get accustomed to having a budget based on the frequency of when we’re getting paid.

And I think by chopping it into bite-sized pieces, as opposed to just putting a big chunk of money in your bank account or your checking account at the beginning of the year, it has several benefits from a psychological perspective.

Tax Payment Methods

So, when you’re paying taxes in retirement, there are basically two methods that you can use. One is the withholding method.

The other is the quarterly estimate method. And with the withholding method on Social Security income, pension income, and many IRA custodians, you can withhold federal income taxes. Some pension plans and IRA custodians will also allow you to withhold state income taxes. And we have a number of clients who, simply by withholding taxes from these sources of income, can fulfill 100% of their tax liability for the year without having to worry about penalties.

Now, many of our wealthier clients can’t fulfill their entire tax liability through the withholding method. So, they have to use something that we call the quarterly estimate method. With the quarterly estimate method, you essentially have to pay a certain percentage on a quarterly basis before pre-specified dates. Some people actually use a combination of both methods.

Some people will just use one or the other. But with the quarterly estimate method, you will have to pay in the last year or the following two amounts: at least 90% of the tax owed for the current year, or 100% of the tax shown for the prior year. And this increases to 110% if you’re a high-income earner.

So, there isn’t a right or wrong method. You can choose the one that you want, but you have to make sure you’re paying your taxes. Otherwise, you can get penalized.

Enjoy Your Money

Now, the final thing that I just want to mention is don’t forget to enjoy your money while you can.

The reason I say that is because, when you look over the last 37 years that we’ve been in business, we tend to see most of our older clients not spending nearly as much as the younger clients. But most of the financial plans and retirement income plans that people have done suggest that they need a certain amount of income their first year in retirement, and that amount just keeps increasing by a specified inflation rate from the day they retire until the day they die.

We don’t see things actually happen that way. We tend to see people have their real spending decrease over time. And if you think this is going to be you, why not push ahead some of your spending earlier on in retirement while your health is there and you can enjoy your money, knowing that your spending might decline down the road?

So, we always encourage people to think about that. I’m not suggesting you should go and blow a bunch of money early, but if you want to spend a little bit more early on in retirement, make sure that you adjust for that in your retirement income projection. Most software programs don’t do that, and people end up working longer than they need to or spending less earlier in retirement than they need to because they don’t factor this into the equation.