Income Plans: Different Than Financial Plans?
Retirement nest eggs do not grow themselves. Getting to retirement typically takes years of hard work, a few good investment choices, and an incredible amount of discipline. But, while the formula for success in the years leading up to retirement, or the accumulation phase, might be more straightforward, it’s typically the decumulation phase that leaves retirees feeling uncertain. In other words, you saved your money to build a nice nest egg, but how do you get it out?
Some of the specific concerns around the decumulation phase include:
- How can I recreate a consistent paycheck in retirement using automated withdrawals?
- What accounts should I withdraw from first?
- How do I create the right mix of growth and income investments to address both the short-term and long-term?
- How do I do all of this and minimize taxes?
While a financial plan that focuses on long-term projections can be useful, an strategic income plan for the decumulation phase (or retirement) is a must.
According to Cerulli Associates, nearly 60% of individuals working with an advisor lack an income plan. That number rises to 80% for those without an advisor.1 Retirement projections are one thing, but a specific income plan that addresses things like the issues above can help mitigate risks, taxes, and reduce uncertainty for retirees.
When developing an income plan, there are typically three approaches used:
When the topic of the order of withdrawals comes up, I usually hear the same rule of thumb. “You should withdraw from your taxable accounts first, then pre-tax accounts, then Roth accounts,” they’ll say. This reflects what’s known as the “One-at-a-Time” approach, where a retiree would take withdrawals from their accounts in sequential order until the first type is depleted, then move on to the next.2
The problem with this method, like all rules of thumb, is that is does not take into account your specific situation. It doesn’t account for Social Security start dates, pension start dates, projected future income tax, or health insurance.
For those that plan to leave their children or beneficiaries an inheritance, this approach assumes you’d like to leave them with the smallest possible tax consequence, while you carry the heavier tax burden during your lifetime. While that could be the goal for some, it certainly is not the goal for all.
The Proportional Approach
One alternative to taking withdrawals from one account at a time is taking a proportional amount of withdrawals from all accounts, depleting each account at the same rate. The idea behind this approach is that it can help smooth out the tax implications of your withdrawals over time, whereas the one-at-a-time approach may cause you to incur big tax hits in years when you would be solely withdrawing from pre-tax accounts.
According to a hypothetical example that Fidelity has published on income planning, the proportional approach can also help your portfolio last longer, primary due to the savings in taxes.2
The proportional approach may also help lower capital gains tax rates, lower Medicare surcharges, and cause less tax on Social Security benefits. Each of these items is negatively affected with a higher taxable income. If you’re able to evenly distribute and avoid large spikes in taxable income, you can help avoid incurring additional taxes and premiums.
The Tactical Approach
This leads us to the final approach to income planning, which is the tactical approach. The tactical approach builds upon the proportional approach in that it is a multi-account withdrawal strategy. However, instead of taking an even percentage from each account, the tactical approach would suggest that you target certain taxable income amounts based on specific goals around capital gains, Social Security, Medicare surcharges, health insurance subsidies, etc.
For example, if a married couple wanted to ensure they paid 0% capital gains tax, they would target an income lower than approximately $78,000 in 2019 through a combination of withdrawals from different account types (IRA, Roth, or taxable). Instead of taking a proportional approach to withdrawals, they could aim for exact income targets like these to achieve more specific goals. While the tactical approach may take the most work, it can also produce the most targeted and customized benefits.
Withdrawal Strategy and Allocation
Having an income plan is important because it should drive your allocation strategy. If you have an IRA, a Roth IRA, and a Joint account, the only withdrawal approach that would suggest the same allocation across the board would be the proportional approach. However, if you plan to withdraw from one account at a time, your shorter-term accounts should likely be invested more conservatively, while the accounts you plan to withdraw from last should likely be invested more aggressively (or with the long-term in mind).
Investing with no consideration of when you will be accessing the money in each account can cause you to sell at inopportune times, unnecessarily locking in short-term losses.
Once Set, Can Things Change?
Of course, things will inevitably change. If you consider all of the possible events that could cause your income plan to change (i.e. Social Security start date, pension start date, required minimum distribution start date, etc.), it’s obvious that your income plan is something that needs to be monitored and updated on a regular basis, along with your investment allocation.
Monitoring doesn’t have to be complex, but it should be consistent to address all the knowns and the unknowns.
Many retirees step into their retirement years with uncertainty about where their income will come from. The unfortunate thing for those that are never given an income plan is the uncertainty seems to linger. But, by simply thinking about the upcoming events in your life and mapping out your expected income sources, you can develop a strategic income plan using one of the approaches discussed above. Your income plan can also provide you with the rationale for how conservative or aggressive you should be invested.
Planning, in general, is crucial to financial success. The same is true for income planning in retirement. You can start today by using these thoughts as a guide. The most important key to success is to start thinking about these things if you’re retired or near retirement. As you do, always remember that “a goal without a plan is just a wish.”
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