Today we’re kicking off this quarter’s education series – Financial Considerations Upon Retirement. The first post in this series discusses issues related to cash flow and taxes. There are several issues to think about before you retire. Give each of these issues an appropriate amount of time because they make a meaningful difference in how long your money might last in retirement. More importantly, these issues can mean the difference between an enjoyable, meaningful retirement and a retirement filled with uncertainty or disappointment. We don’t want you to worry about money during retirement. And if you walk through these questions with the help of a professional, you won’t have to.
Will your cash flow needs change?
Upon retirement, some folks continue to spend similar amounts of money to what they spent pre-retirement. Others might spend more money on leisure activities including travel, entertainment, and hobbies. The reality is that you’ll have extra time, and it’s easy to fill that time with activities that cost money. However, whether your expenses change is unique based on what your ideal retirement looks like. If you will occupy your time by hitting the public trails on your bicycle, reading, and gardening, you may not see much of an increase in your expenses.
Whatever the case, think about how you want your typical weeks to look during retirement. And also consider the occasional larger expenses throughout the year (like travelling or home improvement projects). Calculate how much you’ll need to spend to fund that type of lifestyle. Hopefully you already have a sense of what you currently spend, which will be good context for forming a new spending plan for retirement. If not, that’s okay, but be intentional about forming a spending plan now.
After you create a spending plan for retirement, you’ll need to figure out how to pay for those expenses. Think about the kinds of income that will be available, e.g., pension, Social Security, dividends and interest, portfolio withdrawals. That’s the more complex part of the retirement planning process, so start with your expenses. Then, as you consider how to pay for those expenses, take a look at the following questions.
Will you receive a pension?
If so, you’ll probably need to choose how you want to receive it. For example, you may choose to receive a monthly income stream for the length of your own life. Alternatively, you may choose to receive it for the length of your own life plus the life of your spouse. Another common option is to receive a lump sum upon retirement. Or maybe you choose something else. Different pension plans have different options.
Whatever your options, consider what makes sense when thinking about your expenses, your life expectancy, your other income streams (like Social Security), and the expected returns in your investment portfolio. Why do expected returns in an investment portfolio matter? Embedded in a pension income stream is an assumed growth rate. For example, let’s say your pension would pay you a lump sum of $114,282 upon retirement. Alternatively, you could elect to receive a monthly check for $4,000, and you expect to live for 25 years. If you invested that lump sum of $114,282, you would only need to generate returns of 3.5% for those 25 years to produce a monthly income stream of $4,000. That means your implied rate of return on that income stream is 3.5%. Do you think your investment portfolio could make more than that? Maybe you choose to take the lump sum.
You’ll also need to consider how comfortable you are with risk. That’s because investment returns are not guaranteed, while the income stream on a pension is guaranteed. Another factor to consider is what happens when you pass away. Depending on what you chose for your claim option, your pension might be worthless upon your death. Choosing a lump sum or a “period certain” option helps mitigate that risk.
Could there be pensions and/or retirement benefits from a previous employer that you may be forgetting?
In our experience, people sometimes forget about pensions from previous employers. In fact, we’ve had clients who didn’t realize they would get a pension from their current employer until we reviewed their retirement benefits with them.
Are you retiring early?
Take extra time to determine how you’ll fund those early years (pre-65ish) of retirement. Typically, IRAs can’t be accessed prior to age 59.5. There are lots of exceptions, but that’s the general rule. However, you can access 401(k) funds at age 55 if you are done working for that employer.
Know that if you want to claim Social Security early because of your early retirement, that can mean a serious reduction in your Social Security benefits compared to delaying until your full retirement age or beyond. Will you be working part-time? Understand that you’re limited to $19,950 of employment income while you’re claiming Social Security prior to your full retirement age.
Will you or your spouse receive a pension from an employer that did not withhold Social Security taxes?
This is a complicated way of pointing out the fact that some people won’t be eligible for Social Security benefits. For various reasons, about 3% of people won’t be eligible for benefits.
Are you currently married?
If so, consider additional Social Security claiming strategies. Married people have hundreds of different claiming strategies. It’s a long-term decision that you only make once. So consider talking to us about your options. I wrote about how it’s really easy to misunderstand the rules in this blog post, and I’d encourage you to heed that warning. Rather than talking to your neighbor about claiming strategies, which can cause a lot of confusion and misunderstanding of the rules, talk to a professional.
Were you married previously and are currently unmarried?
People who were previously married and are currently single might be eligible for Social Security benefits based on their previous spouse’s earnings. Consider this:
If the marriage lasted 10 years and ended in divorce, you may be eligible for benefits under your ex-spouse’s record. Similarly, if the marriage lasted more than nine months and ended due to your spouse passing away, you may be eligible for benefits under your deceased spouse’s record.
Again, these are complex issues best discussed with an expert.
Do you expect to have large required minimum distributions?
Strategies to reduce the RMD, such as Roth conversions, might be worthwhile considerations. Large RMDs are a real possibility if you’ve saved a lot in pretax retirement accounts such as Traditional IRAs, a 401(k) or 403(b), Simple or SEP IRAs, or others. Sometimes, those push you into higher tax brackets later in retirement, compared to lower tax brackets in the early years of retirement. You can “smooth out the tax bill” and try to avoid jumping brackets by doing Roth conversions. This might not only help you lower your lifetime tax bill, but it also might help you give more tax-free assets to heirs after you pass away.
Another way to lower taxes on RMDs during retirement is by donating all or a portion of your RMD to charity. By giving directly from your retirement account to the charity – without first transferring the RMD to your own personal account – you might not have to claim that portion of your RMD as income. Read more about that strategy here, and talk to a tax professional about how the rules apply to you.
Do you expect your income to be lower at retirement?
If you expect your income to be lower upon retirement, consider deferring any Roth conversions until you are in a lower tax bracket. Put differently, if you’re in a higher tax bracket now, focus on things to reduce your taxable income now. Then in the early years of retirement before Social Security or RMDs kick in, you might do some Roth conversions to fill up those low tax brackets. However, you’ll want to consider how Roth conversions impact your capital gains tax rate, Medicare IRMAA, and subsidies you might be receiving for health insurance premiums. A qualified tax planner or financial planner can help you think through all of these questions. Contact us to see if we could help with your specific situation.