How to Pay for Retirement (Part Two)

In Part Two of our series on how to pay for retirement, we discuss three additional ways to raise cash in retirement.

How to pay for retirement is a crucial question that should be answered before your actual retirement date. Social Security income is rarely enough. Without a financial plan in place, one can also not assume that their retirement savings is sufficient to support their ideal retirement lifestyle.

So ask yourself: How will you generate cash in retirement when you are no longer earning the full-time salary you were accustomed to making?

6 Ways to Pay for Retirement

In How to Pay for Retirement (Part One), we discussed three sources of income that can provide you with cash in retirement: Social Security Income, working part-time, and drawing from a pension.

Here, in Part Two of our series on how to pay for retirement, we discuss the advantages and disadvantages of accessing cash in the following ways:

Distributions from Retirement Accounts

So far, we have talked about how to pay for retirement using non-retirement sources of income. At some point, you will need to access your retirement accounts, which may include an IRA, 401(k), or 403(b) plan.

Advantages to Taking Distributions from Retirement Accounts

There are advantages to taking distributions from a retirement account before taking social security income or pension.

  • It allows you to delay taking social security income so you can accrue a higher lifetime benefit.
  • Retirement plan distributions are more tax-efficient than earned income.
  • You can take advantage of lower tax brackets.

Social Security Higher Lifetime Benefit. Taking withdrawals from your retirement accounts rather than social security can allow your social security income to grow (up until age 70). Waiting until age 70 to collect could result in an increase of 33% from what you would have received if you collected at your Full Retirement Age. The nice thing about that is subsequent cost-of-living increases are based on the higher amount, providing you with more income to pay for retirement.

Tax-Efficiency. Retirement plan withdrawals are not as tax-efficient as social security withdrawals, but they are more tax-efficient than part-time earnings. Retirement plan withdrawals from a Traditional IRA or 401(k) are taxed at ordinary income tax rates. Withdrawals from a Roth IRA or Roth 401(k) generally are tax-free, which can be a good way to generate cash in retirement while your social security income accrues.

Lower Tax Bracket. There may be a gap between when you retire and when you will be required to take money from your retirement accounts. During those years, you may find yourself in a low tax bracket. Taking withdrawals from a 401(k) or IRA and paying tax at a low rate, one that may be lower than the one you will pay once you are required to take funds from the account, can be a good strategy.

Disadvantages to Taking Distributions from Retirement Accounts

There are, of course, some disadvantages to accessing your retirement accounts first.

  • Retirement account distributions may not be tax-efficient for certain retirees.
  • The amount to be withdrawn is not fixed.
  • You run the risk of depleting the account.

If you are in a high tax bracket, taking money from your retirement accounts can result in higher taxes. In addition to higher taxes, your Medicare Part B premiums may go up because premiums are higher for people whose income exceeds a certain threshold. Every dollar lost to taxes or Medicare Part B premiums is one less dollar you have for living expenses. For many people, that is not optimal. This makes taking withdrawals from retirement accounts a complicated decision that is not suitable for everyone.

There also is a risk of outliving your retirement accounts. Taking out too much at an early age can put you behind the eight ball, especially when coupled with poor investment returns. Because the amount you are withdrawing is not fixed by someone else, it is up to you to ensure you are not taking out too much. You can withdraw the same amount each month, but you need to be disciplined and stick with the plan, even if you think you need more money that month.

Bank Accounts

When thinking about how to pay for retirement, withdrawing cash needs from a savings account is often overlooked. It does have a place in a retiree’s toolbox for the following reasons:

  • Bank accounts are easy to access.
  • Liquid funds are tax-efficient.
  • There is no fluctuation in principle like you might experience in the stock market.

Easy to Access. Bank account funds are among the easiest to access. If left in your checking account (which is not advisable), there is nothing to do until the account needs to be replenished. If kept in a savings or money market account, you can link them to your checking account and pay bills. Connecting the accounts can also act as overdraft protection for your checking account. Any time there are insufficient funds in the checking account to cover a check, the amount is automatically swept from the savings account to the checking account.

Tax-Efficiency. Taking your cash needs from a checking or savings account is as tax-efficient as it gets since no income tax is incurred when you withdraw funds from a bank account. If you need $50,000 for the year, you withdraw $50,000 from the savings account, and no tax is due.

The Principle is Protected. The other advantage to using a bank account is that the account principal does not fluctuate based on how the markets are doing. The value only increases or decreases if you deposit or withdraw money. Any interest earned will increase the account value as well. But you can be sure the amount in the account is what you have available to spend even if the stock market is declining.

Disadvantages to Using a Bank Account to Pay for Retirement

There are some disadvantages to relying too heavily on funds from a savings account for your cash needs. For example:

  • A bank account’s value is likely to be eroded by inflation.
  • Once used, you may not have liquid funds available for emergency needs.

Account Value Erosion. In a perfect world, we would all prefer investments that only go up and never down. While that is true for a bank account, the problem is the amount they can go up is minimal. When they do go up a lot, it is because inflation has gone up even more. Unfortunately, this is not a good long-term strategy for people faced with a thirty-year retirement.

The concept of having to accept principle fluctuation is a tough one for retirees to handle. Declines in account values due to the stock market are considered detrimental to maintaining one’s lifestyle. However, being invested in the market is the only way to outpace inflation.

Lack of Emergency Funds. The other disadvantage to using too much of your savings is that you may not have enough funds in the savings account to pay for what is needed if an emergency arises. Care should be taken to not reduce the balance in the account so much that you put yourself at risk in a crisis.

So, the burning question becomes, “how much should you keep in bank accounts to help pay for retirement?” We recommend keeping three years of your cash needs in cash and cash equivalents. Rather than keeping funds in a checking or savings account, we suggest using Certificates of Deposit (CDs) or Short-Term Bond Funds, which provide a higher return than cash in the bank.

Brokerage Accounts

The final source of funds to pay for retirement is a brokerage account. You may want to consider using a brokerage account to help pay for retirement before accessing other income sources for the following reasons:

  • Brokerage account withdrawals are more tax-efficient than IRA and 401(k) withdrawals.
  • Brokerage accounts are likely to earn more than bank accounts.
  • Accessing brokerage accounts before Social Security allows for social security benefits to accrue longer.
  • Using cash from brokerage accounts gives retirement accounts more time to grow.

Distributions from brokerage accounts are more tax-efficient than retirement plan distributions. This is because only the portion of the brokerage account’s distribution representing the gain (amount over what you initially invested) is subject to tax. The amount of tax depends on how long you held the investment you sold to make the distribution. If held for one year or less, then the gain is taxed at short-term capital gains rates, which are the same as ordinary income tax rates. If the investment was held for more than one year, the gain is taxed at long-term capital gains rates, which will always be lower than your ordinary income tax rate. Therefore, the same investment purchased in a brokerage account and a retirement account (such as an IRA) will result in a different amount of tax owed upon withdrawal.

Here is an example: Bob, age 65, buys 100 shares of XYZ mutual fund in his brokerage account and his IRA account, investing $12,000 into each account. Three years later, XYZ mutual fund is worth $15,000 in each account. He realizes he could use the $15,000 to pay his property tax bill for the year.

What is the most tax-efficient way for Bob to withdraw the money?

If Bob sells XYZ mutual fund in the IRA and withdraws the $15,000, he will pay ordinary income tax on the entire amount. If he is in the 30% ordinary income tax bracket, he will pay $4,500 of income tax and be left with $10,500.

If he sells XYZ mutual fund in his brokerage account and withdraws the $15,000, he will pay long-term capital gains tax of $450 ($3,000 gain * 15%), leaving him with $14,550. Clearly, he should sell XYZ mutual fund in the brokerage account to pay less tax.

Investments in brokerage accounts can be made into many different types of investments. This can include cash, stocks, bonds, and mutual funds. The latter three are likely to make more money than money stored in a bank account.

Using the brokerage account for your cash needs can allow your social security benefits to continue to accrue and allow your retirement accounts to continue to grow tax-deferred, which also is a big plus for using a brokerage account.

Disadvantages to Using Brokerage Accounts for Cash Needs in Retirement

There are, of course, disadvantages to using a brokerage account to provide cash in retirement. The most significant disadvantage may be that when making changes to a brokerage account by selling an investment, there likely will be tax owed, even if you do not withdraw the money for your needs.

Using the same example as above, let’s say that Bob decides he no longer wants to invest in XYZ mutual fund and has found a better mutual fund instead. If he sells XYZ mutual fund for $15,000 in his IRA account and buys ABC mutual fund, he will not pay any income tax on that transaction because he did not withdraw any funds from the IRA.

If he does the same thing in the brokerage account, he will pay income tax, in this case, $450 for the privilege of switching investments. So, rather than investing $15,000 into ABC mutual fund, he can only invest $14,550 because he will need to set aside $450 to pay the tax on the gain on the sale.

There are many ways to access cash in retirement to pay for expenses. The six methods described in this two-part series on how to pay for retirement are not mutually exclusive and can be (and usually are) combined. What is right for you may not be suitable for someone else. Figuring out what works best is not easy, but understanding your options and the advantages and disadvantages of each one can help you reach the best decision for you and your family.

To review the first three sources we discussed – Social Security Benefits, Part-Time Work Opportunities, and Drawing from Pension Income – read How to Pay for Retirement (Part One).

Should you require assistance analyzing your options, do not hesitate to contact an EKS Associates advisor.

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