Maximizing Your Retirement Income

One common goal that all Americans share is to retire as early as they can. Maximizing your retirement income will give you the option to do so as early as possible. During our working years, we are constantly juggling the responsibilities of supporting a family, career growth, and paying down the mortgage. 

But retirement is a time to focus on yourself and do the things in life you have always wanted to do. Prior to retirement, we all want to know how much can we spend without running out of money. Maximizing your retirement income is the key to optimizing how much you can spend. 

The two key components to maximizing your retirement income are how much you’ve saved for retirement and how much you need to withdraw from your nest egg every year. There are certainly a number of variables to maximizing your retirement income. But the three most important factors are determining your income needs, structuring your retirement income, and reducing taxes.

Determining Your Income Needs

Before you can identify opportunities to maximize your retirement income, you need to determine how much income you need to cover your expenses. It’s important to create a budget that reflects all of your expenses. Next, you need to total up all of your income sources in retirement. 

You are essentially creating a cash flow statement that will tell you what your income shortfall will be. This shortfall amount reflects what you will need to withdraw from your retirement accounts.

However, your income and expenses change quite frequently in retirement. So it’s important to create cash flow projections to understand how your income needs will change in future years.

Taxes

Taxes are one of the biggest obstacles in retirement and are crucial to maximizing your retirement income. Your income will fluctuate throughout retirement. Knowing your federal and state marginal income tax rate will be helpful in tax planning.

It will affect decisions such as when to take social security or pension income. It will also help determine which type of retirement accounts to withdraw from. In years when income is higher, your goal is to use tax planning strategies to reduce your income. 

There will also be years when your income is lower than it will be in the future. In those years it may make sense to utilize strategies such as Roth Conversions. The goal is to pay tax on income at lower tax rates. As you can see, taxes are at the center of maximizing your retirement income.

Structuring Retirement Income

Running cash flow projections through the end of your retirement will allow you to observe changes in your income. This fluctuation of income during retirement is common for married couples of different ages.

An age gap between spouses often means that retirement ages are different. This means that Social Security and Required Minimum Distributions (RMD’s) will most likely begin at different times as well.

Structuring your fixed income sources while paying the least amount of taxes is how you optimize retirement income.

Social Security

Social Security is the primary fixed income source in retirement for most Americans. You should know what your benefit is at your full retirement age. It’s also important to know what happens if you delay it or take it early. And also understanding which circumstances make your Social Security income taxable.

Your full retirement age is the age when you can take social security and receive your full benefit. The earliest you can take Social Security is age 62, but your benefit can be reduced as much as 30%. Your benefit can also increase by up to 8% per year by delaying until age 70. 

Some people take their Social Security benefit at age 62 and continue working. The consequence is that your benefit may be reduced by as much as $1 for every $3 of income earnings. Also, up to 85% of Social Security benefits can be taxable depending upon your other household income. 

Making the wrong decision with your Social Security can cost you a lot through lost income and higher taxes. There are a number of other Social Security strategies and pitfalls that you want to be aware of prior to making your decision on your benefit.

Pensions

Pensions are not as common as they were in the past, but many federal and state employees rely on them as their primary source of fixed income in retirement. If you are a public employee that will receive a pension, it’s important to know that your Social Security benefit can be offset by the Windfall Elimination Provision and Government Pension Offsett.

Choosing the right pension income option is crucial to maximizing your retirement income and minimizing your taxes in retirement. There are 3 primary payout options, but there can be more options offered by your employer.

Life Only

A life only option means that your pension will provide you with an income stream for your life only. If you pass away shortly after initiating this option, your payments will cease completely. If you live to age 120, the pension will continue to pay income until that age. This option will typically pay out the highest monthly benefit vs. your other options.

Joint Survivor

Married couples need to consider income needs for each spouse in the event of death. For example, if you select a 50% joint survivor option, that means that half of the monthly benefit you will receive during your lifetime will go to your spouse in the event you were to pass away. Many pension plans will offer survivorship options of 50%, 75%, and 100%. However, these options will vary considerably from one employer to another.

Lump-Sum

Not all pension plans will offer a lump-sum benefit, but some do. Pension participants should calculate whether taking a lump sum and rolling it over into an IRA is better than the income options offered. A dollar you receive 10 years from now is not worth the same as a dollar today. So you must factor in the opportunity cost by not having the money in your hand today to invest.

Other Income Sources

Some other common income sources in retirement are employment income, self-employment income and rental real estate income. If a spouse has yet to retire and is still employed full-time or is self-employed, there are ways to defer some of their income by saving to retirement accounts in an effort to keep taxes lower.

Those who are still working full-time have the opportunity to defer some of their income to a defined contribution retirement plan such as a 401k. Also, if you have a high-deductible health insurance plan, you can also contribute to an HSA account, which will lower your income. 

Self-employed individuals, including those who receive 1099 income can contribute to a number of different types of retirement accounts. Solo 401k’s, solo Roth 401k’s, SIMPLE IRA’s and a number of other retirement plans are available to self-employed individuals to save more tax-efficiently. These accounts can help you reduce your tax liabilities throughout retirement.

Rental Real Estate Income

Rental real estate income is another primary source of income for retirees. It is considered a passive activity and the the income generated from this activity is subject to a special set of tax rules. 

Rental real estate has a number of different tax benefits, such as depreciation which offsets the gross income generated by the activity. Knowing how passive income and losses affect your tax return will allow you to plan better when developing your retirement income strategy.

Reducing Taxes

As I mentioned before, taxes are at the center of maximizing your retirement income. You have to know how to calculate your marginal tax rate and how our income tax schedule works. Your marginal tax rate represents the percentage of your income you pay on your last dollar earned.

Federal income tax ranges can increase by 8 or even 10%. For example, in 2020 the brackets are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Notice there is a big jump in tax rate from the 12% to the 22%. There is another significant increase from the 24% bracket to the 32% bracket.

If you are at the high end of the 12% bracket, you will want to be very careful with your income decisions. Increasing your income could bump you up to the next bracket where you will now pay an extra 10% tax since you now sit in the 22% bracket.

Choosing Which Accounts to Draw from

You have spent your entire life building up your nest egg. And hopefully, you have managed to save into tax-deferred, tax-free and taxable accounts. These accounts are all taxed differently so determining where your withdrawals will come can have a huge impact on your taxes.

If you are in a 12% tax bracket and close the 22% bracket, a withdrawal from your tax-deferred IRA can bump you into the 22% bracket increasing your tax liability on the withdrawal. A withdrawal from a tax-free or taxable account could result in zero tax liability. 

Also, the sequence of your withdrawals from these accounts can have a significant impact on your overall ending wealth. The most tax-efficient withdrawal strategy is to draw from taxable accounts first, then tax-deferred and lastly tax-free, generally speaking. Consulting with your financial planner is always recommended when making these types of decisions.

Roth Conversions

If you never made Roth contributions, then you are missing a tax-free source of income in retirement. However, it’s not too late to start creating a tax-free pool even after you stop working. 

While you must have earned income to make a Roth contribution, you don’t need to be working to perform a Roth conversion. Additionally, there is no income limitation on Roth conversions like there are with Roth contributions. 

Roth Conversion Methodology

The process of a Roth conversion is to convert funds from a tax-deferred account like a Traditional IRA to a Roth IRA account. This strategy is best utilized in a lower-income year when taxes are low. The entire amount of the Roth conversion gets added to your income and taxed at ordinary income tax rates.

For example, if you were in the 12% tax bracket but expect to be in a 22% tax bracket in the future, then it may behoove you to perform a Roth conversion to get your income up to where the 22% bracket starts. 

You are effectively paying more tax, but are utilizing the room you have in the 12% bracket. The goal is to avoid paying more tax down the road in the 22% bracket (or higher). This helps to equalize your taxes throughout retirement.

Maximizing your income in retirement really comes down to paying taxes at the lowest rates. Even if that means increasing your income in some years.

Tax-efficient Investing

Asset Location

Another source of income for many retirees is portfolio income in the forms of dividends and interest from stocks and bonds. Dividends are taxed at capital gains tax rates, which are always lower than income tax rates. Interest is taxed at ordinary income tax rates so it’s important to know how much total income your portfolio is producing.

Constructing your asset allocation entails choosing which asset classes you will invest in. But you also need to determine which retirement accounts will own the different asset classes. Asset classes that pay interest like real estate funds should not be in taxable accounts. The reason is that the interest is taxable to you as ordinary income. 

A real estate fund owned in a Traditional IRA account would be more suitable since none of the income produced within the account is taxable. You only pay tax on what is withdrawn. Conversely, you would want to own stocks that pay dividends in your taxable account so you can tax advantage of capital gains tax rates.

Municipal Bonds

If you are in a higher tax bracket, then it may make some sense to invest in municipal bonds. Municipal bonds issued from your state of residence pays federal and state tax-exempt interest. That’s right, you pay zero tax on the interest. It would only make sense to own these securities in your taxable account, not qualified accounts such as Traditional and Roth IRA’s.

Tax-loss Harvesting

Another benefit to assets subject to capital gains tax rates is the ability to use losses to offset gains. Tax-loss harvesting is a portfolio management strategy that takes advantage of market volatility. You can use any realized portfolio losses in the current year to offset any realized gains you may have in the same year. 

If you don’t have any gains, these losses can be carried forward indefinitely to use in future years. If you never have any realized gains, you can use $3,000 from your carryforward loss balance as a deduction every year. 

 

We all want to find the most optimal path towards our goals, whatever they may be. Maximizing your retirement income is no different. The ultimate goal for most Americans is to spend as much as they can or want without jeopardizing their future.

In the case of retirement, the biggest risk is outliving your assets during your lifetime. This is why it is so important to understand your income needs throughout retirement. Then, you can structure your income sources and create a tax minimization plan to optimize your retirement income. 



Author: Danny Michael
Danny G. Michael has 17 years of experience as an advisor working with individuals, families and business owners. Danny has also been a Certified Financial Planner™ since 2006 and is also an Accredited Investment Fiduciary.

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