Most of us think that saving is the most demanding part of planning and preparing for retirement. It takes discipline, persistence and commitment to accumulate enough resources to fund a 30+ year retirement. But, even after you’ve accumulated those resources, there are challenges. One of the greatest of these is generating income. How do you create income in retirement?
Previously, we explored several sources of retirement income, including Social Security, employer sponsored retirement plans, IRAs and Roth IRAs. Now, we’ll consider several other sources of retirement income, including part-time work, small business installment sales, rental property income, annuities, life insurance, charitable gift annuities and reverse mortgages. And we’ll again consider their safety, duration, tax efficiency and inflation adjustment.
One of the most important aspects of a fulfilling retirement is finding things to do that you enjoy. It might be spending time with family and friends, exercising, pursuing hobbies, or engaging in volunteer activities. It could also include continuing to work on a part-time basis.
Your last employer might allow you to continue to work on a part-time basis. Alternatively, you might work for another company or work as an independent consultant. You could also start a part-time business.
The income you earn from part-time work won’t be guaranteed. It might stop because your employer ends it or because you decide to fully retire. Similarly, there won’t be guarantees about how long your part-time work lasts. It might last a few months, or it might continue well into your older years. Some people – like attorneys, academics and self-employed professionals – work well into their 80s and even their 90s.
In general, the income you earn from part-time work will be taxed as ordinary income. This income won’t be automatically adjusted for inflation.
Small Business Installment Sale
There are millions of small businesses in the United States and, collectively, they employ more people than large corporations and the public sector.
If you own a small business, it’s probably been your primary source of income. What happens when you decide that it’s time to stop running the business and transition into retirement? You’ll need to sell the business and convert your ownership stake into dollars that will fund your retirement.
Small businesses are often sold internally, to another family member who’s involved in the business or to one or more key employees who are integral to the operation of the business. However, typically these individuals don’t have the resources to just write a check to pay for the value of the business. Instead, they often pay for the business in installments over some period.
If you plan to sell your interest in a small business, you should realize that the transaction involves risk. While you’ll undoubtedly want to have a written legal sales agreement in place with the buyer, that agreement doesn’t guarantee that you’ll actually receive the purchase installments promised by the buyer. Lots of things can go wrong. The business can struggle or even fail for various reasons. If it does, the buyer will probably be unable to pay you the remaining installments.
If all goes well and you are receiving the promised installments, they won’t go on forever. At the end of the installment period, the sale will be complete and the payments will end. You’ll need to plan for other income sources to replace what you received from the sale of your business.
The Internal Revenue Service taxes installment sales in a favorable manner for business owners. The gain associated with the payments is included in income in the year it’s received. The portion of the payment that is considered basis (your original investment) isn’t included in income. This tax treatment will allow you to spread the gain over the entire installment period. But, the payments from an installment sale are generally considered ordinary income and, unfortunately, not capital gains.
Installment sales aren’t structured to include adjustments for inflation.
Rental Property Income
If you own rental property, you’ll have a supplemental source of income in retirement. Owning rental property is a popular income source, particularly for people who aren’t comfortable with, or don’t “believe” in, investing in the stock market.
Is rental property a safe investment? It depends on the property. If you own a residential or commercial property that’s well-maintained, in a desirable area, and with strong rental history, your income from the property is probably fairly reliable. If, on the other hand, the property needs work, is in a troubled area, and has a spotty rental history, the rental income from it will be less predictable.
As you get older, you may find owning and managing rental property less attractive. You may grow weary of repairs, tenant interactions and laws that limit your ability to control the property. You could bring in a property manager to manage the property for you. But that expense may make ongoing ownership of the property unattractive. You could also sell the property and reinvest the proceeds in another income-generating investment (such as real estate investment trusts or an annuity).
The taxation of rental property is complex. The tax code makes owning rental property attractive, at least until you sell the property. A detailed explanation of this is beyond the scope of this article.
A major attraction of rental property income is that it generally rises over time. Property owners can raise the rent in line with other similar properties in the area. At a minimum, you can typically increase the rent over time to track with the rate of inflation.
There are several ways to generate income from an annuity. For this article, we’ll focus on the basic “immediate” annuity, which involves giving an insurance company a lump sum of money in return for stream of income.
The income stream from an immediate annuity is guaranteed by the insurance company. There have been but a few instances in which an insurance company has failed in the United States. So, it’s rare. In addition, all states have a “state guarantee fund” which protects insurance contract holders in the event that an insurance company operating in the state defaults on payments or becomes insolvent. Nevertheless, it’s smart to purchase insurance products from large, long-established and highly-rated insurance companies.
The duration of an annuity is one of its most compelling features. The payments are guaranteed for the period you select which, for those in retirement, is usually for life. This feature makes annuities unique and highly attractive. They offer one of the only income sources that you can’t outlive.
The taxation of an immediate annuity depends on whether it’s purchased inside a qualified retirement account like an IRA, or outside using non-qualified or after-tax dollars. If it’s the former, the payments are fully taxable as ordinary income. If it’s the latter, the payments are composed of two parts: a return of principal and taxable earnings. The return of principal is tax-free. The earnings are taxed as ordinary income.
Annuities are rarely offered with a cost-of-living adjustment feature. The amount of the payments generally remains the same for life.
There’s another insurance product that can be used to generate income in retirement. Cash value or permanent (but not term) life insurance can be used to provide income in several ways.
As we discussed above, income from an insurance company isn’t guaranteed. So, make sure you purchase insurance products from financially sound companies.
You could take loans from your life insurance contract to provide supplemental income. Loans are tax-free. However, interest accumulates on the loan. You’ll need to make certain that the loan doesn’t overwhelm the policy and cause it to “lapse”. A lapsed life insurance contract can result in a significant taxable event and should be avoided.
Also, be careful to avoid creating a “modified endowment contract” scenario in which the withdrawals from the life insurance policy are taxed as “last-in, first-out” and may be subject to a 10% penalty. Also, loans withdrawals aren’t guaranteed to last for a specified period.
Alternatively, you could make a partial surrender of your life insurance contract. As long as you don’t take more than your total premiums paid (i.e., your “cost basis”), the withdrawals are income tax-free. The surrender will reduce the amount of the life insurance death benefit.
Finally, you could also exchange your life insurance contract for an income annuity. Such an exchange isn’t subject to taxation. But, as described above, the income you receive from the annuity will be subject to taxation.
There’s no way to insulate withdrawals from a life insurance policy from inflation.
Charitable Gift Annuities
One of the more sophisticated ways to create income in retirement involves making a gift to a non-profit organization. You, as the donor, make a gift to a charitable organization that’s important to you. The charity would then provide you with payments for life. At your death, the assets you gifted are retained by the organization.
The income you receive from the charitable organization isn’t guaranteed. If the charity were to default on the obligation, your payments could end prematurely. A charitable gift annuity wouldn’t be guaranteed by a state guarantee association.
If you wish to donate to a charity, you have highly appreciated securities or property, and you’re seeking to generate additional income in retirement, you should consider a “charitable gift annuity”.
The taxation of a charitable gift annuity is complex and beyond the scope of this article. But, in general, you would receive a tax deduction for the amount of your gift in excess of the present value of the income you’re expected to receive over your lifetime. The annuity payments are considered a partial tax-free return of your gift to the charity. The remainder of the payments are considered ordinary income.
The payments from a charitable gift annuity aren’t indexed for inflation. A payment amount is calculated when the arrangement is established and it remains fixed for life.
Our last strategy is the home equity conversion mortgage (or “HECM”) or, as it is more commonly known, a reverse mortgage. If you’re 62 or older and are willing to consider tapping into the value of your home to create retirement income, a reverse mortgage may be a good option.
With a reverse mortgage, you borrow from a financial institution against the equity in your home. There are several ways in which you may receive payments. The “tenure reverse mortgage” provides equal payments for life as long as you meet certain requirements, including paying for homeowner’s insurance, property taxes and necessary home repairs. For most people, this is probably the best way to create retirement income.
The payments are guaranteed by the lender. If the lender were to default on its payments, you would be forced to unwind the reverse mortgage. But we haven’t found any instance of this occurring.
The payments from a reverse mortgage are tax-free, because you’re borrowing against equity in your home. You aren’t required to make interest payments on the loan. Instead, the interest is rolled into the loan. When you die or no longer have the home as your primary residence, the loan is repayable. If you’ve moved, you can sell the home and repay the loan. If you’ve passed away, your heirs can pay off the loan and retain the home, or the lender will sell the home to do so.
The payments from a reverse mortgage aren’t indexed for inflation. A reverse mortgage is a complex financial arrangement and an in-depth review is beyond the scope of this article. But they represent a compelling way for homeowners to create supplemental income in retirement.
Getting Help with Retirement Income Planning
If you need help putting together your income plan for retirement, consider working with a Certified Financial Planner™ (CFP®), Certified Public Accountant (CPA) or a Chartered Financial Consultant® (ChFC®) or an RICP (Retirement Income Certified Professional®). Advisors who hold these designations have met rigorous educational, experience and ethics requirements.
If you’re looking for help with retirement income planning, contact us today to see how our team at Springwater Wealth can help you.