If you’re a Boomer (born 1946-1964), you’re either rapidly approaching retirement or you’re already retired. You’ve spent many years saving for retirement. While saving isn’t easy – just look at the dismal savings rate for most Americans as evidence – transitioning from saving to spending is even more challenging.
Once you stop working and earning an income, you’ll need new sources of income to maintain your desired lifestyle. There are a variety of ways to create income in retirement. Let’s review the most common ways, and assess them for safety, duration, tax efficiency, and whether they’re adjusted for inflation.
In this review, we’ll explore Social Security, employer sponsored retirement plans, traditional IRAs and Roth IRAs. In a coming review, we’ll look at part-time work, small business installment sales, rental property income, annuities, life insurance, charitable gift annuities and reverse mortgages.
Your most attractive source of income in retirement is Social Security. The benefit you’ll receive is directly related to your earnings history. The more you earned and the longer you did so, the greater your benefit.
Your Social Security benefit is considered “normal” when you reach your full retirement age (or “FRA”). Depending on when you were born, your FRA is somewhere between age 66 and 67.
You can elect to begin receiving your benefits as early as age 62 but, if you do so, your benefits will be permanently reduced by a small percentage for each month you retire before your FRA. Alternatively, you can delay receiving your benefits up to age 70, in which case your benefits will be permanently increased by a small percentage for each month you delay.
Your Social Security income is guaranteed by the federal government. While you may be concerned about the solvency of the Social Security system, it’s extremely unlikely that Boomers will end up receiving less income than promised.
Your Social Security benefit will be paid for as long as you live. Further, it will be increased for inflation throughout your retirement.
Your overall financial situation will determine whether your Social Security benefit will be subject to taxes. You should work with a tax professional and financial planner to minimize or avoid paying taxes on your Social Security income.
Employer Sponsored Defined Benefit Pension Plan
If you worked for a large corporation or a government entity, you may be eligible for a defined benefit pension when you retire. Your benefit will be calculated using a formula based on your salary history and the length of your employment with the plan sponsor. When you retire, you’ll receive an income that is paid for life (i.e. an annuity income stream). If you’re married, you’ll most likely want to take the “joint-and-survivor” annuity option, which will ensure that your spouse or partner receives part or all of your benefit if you predecease them.
These plans are generally safe, because they’re insured by the federal government through the Pension Benefit Guaranty Corporation (the “PBGC”). So, if your corporate employer defaults on its obligation to pay you, the PBGC will step in and pay most or all the benefit your employer promised. Public pensions are not guaranteed, however. But, there’s rarely been a default of a government entity.
Income from a defined benefit pension plan is subject to ordinary income tax, and the payments may not be indexed for inflation.
Employer Sponsored Defined Contribution Plan
Most employers, even small ones and non-profits, offer some kind of qualified retirement plan. These plan meet requirements of the Internal Revenue Code of the Internal Revenue Service. Your employer sponsors the plan and receives some tax benefits, and you receive certain tax benefits as a participant. 401(k) and 403(b) plans are the most common types of defined contribution plan.
As an employee, you can make contributions to your account through payroll deductions. Your contributions either a fixed dollar amount or a percentage of salary per pay period. In addition, your employer may match a portion of your contributions. Your participation in the plan is voluntary, and there are limits on how much you may contribute.
Defined contribution plans are participant-directed, which means that you’re responsible for deciding how you’d like your account invested. As the plan sponsor, your employer will have created an investment menu comprised of mutual funds, exchange-traded funds, target-date funds, and/or retirement date funds. Some plans will allow you to invest “outside the menu” using a self-directed brokerage account.
When you retire, you’ll most likely roll over your defined contribution account into an Individual Retirement Account (or “IRA”) in your name. This type of roll over is tax-free. You’ll then be able to take income distributions from your IRA when you’re ready. You can start taking penalty-free distributions as early as age 59 ½. Once you turn 72, you’re required to begin taking so-called “required minimum distributions”.
Unlike with a defined benefit plan, there are no income guarantees with a defined contribution plan.
The distributions from your IRA are considered ordinary income. How long you’ll be able to take distributions from your account before it’s depleted will depend on the size and frequency of the withdrawals, as well as the performance of the investments in your account.
Non-Qualified Employer Sponsored Retirement Benefits
Your employer may also offer a so-called “deferred compensation” plan, which allows you to postpone receiving some portion of your income in any given year into the future. These plans are considered “non-qualified” because they don’t fall under the traditional qualified plan rules. These plans are typically offered to allow highly compensated employees the ability to save more than is allowed under a traditional qualified retirement plan.
The income you defer into a non-qualified plan is held by your employer and isn’t subject to taxation until you receive it. While your employer retains this income, it isn’t protected from loss – it’s considered an asset of the company and therefore at risk in case of bankruptcy. There have been instances in which non-qualified deferred compensation plans have been seized by an employer’s creditors. In contrast, qualified plans are protected by the Employee Retirement Income Security Act (“ERISA”).
Typically, in the year you elect to defer income into the plan, you’ll also need to specify when you’d lie to receive it. For example, you may elect “lump sum at retirement”, or “10 equal instalments beginning at retirement”. Most plans will not allow you to change the election once it’s made. When you receive distributions from the plan, they’ll be taxed as ordinary income. The distributions won’t be indexed for inflation.
Earlier, we mentioned IRAs. You may be able to contribute to an IRA in addition to deferring salary into your employer-sponsored retirement plan. The IRS has rules about who’s eligible to contribute to an IRA. There are also limits on how much you may contribute each year. Contributions to a traditional IRA are generally tax-deductible.
IRAs offer tax-deferred growth, which means you’ll pay taxes on your investment gains only when you take distributions. As we noted above, those distributions are subject to ordinary income tax.
You have virtually unlimited investment options in your IRA – individual stocks and bonds, mutual funds, exchange-traded funds, and more. There are no income guarantees with IRAs, as we noted before. The size and frequency of your withdrawals, together with the account’s investment performance, will determine how long your money lasts. Your distributions aren’t automatically indexed for inflation.
Unlike a traditional IRA, a Roth IRA is funded with after-tax contributions. The IRS has rules about who’s eligible to contribute to a Roth IRA, and there are also limits on how much you may contribute each year.
Roth IRAs offer tax-free growth. You won’t pay tax on your investment gains inside the account, and distributions from a Roth IRA are generally tax-free.
Unlike with a traditional IRA, there are no mandatory distribution rules for Roth IRAs. But, if you decide to take distributions, their size and frequency, together with the account’s investment performance, will determine how long your money lasts.
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.