With the growth in popularity of 401k plans, it’s common for employees to accumulate large account balances through disciplined savings and the power of compound investment growth. Much of the attention over the years has centered around the habits and skills needed to effectively create a significant retirement nest egg.
But, as retiring employees are discovering, accumulating the nest egg is only half the challenge. The other half is all about how you distribute income from your nest egg once you retire. The more efficient your plan, the longer the money lasts. There is growing evidence and concern that employees aren’t well prepared for the task of converting a lump sum of money into an income stream that lasts for their lifetime.
Here are the primary issues:
- Ideally, preparation should begin well before retirement in the preretirement working years.
- The “optimal plan” requires different and specialized tax and investment techniques coupled with some actuarial modeling. It can feel daunting and the uncertainty can lead to inertia.
- As cognitive abilities decline, it may prove difficult to follow through with the process.
There is no “one size fits all” retirement income strategy, but here are the main ingredients. If you’re doing it yourself or when interviewing a financial planner, make sure these areas get addressed thoughtfully:
- Do the math: Start with a retirement income analysis that determines how much income your nest egg can support under reasonable assumptions. Without this benchmark, it’s very hard to plan or manage your income in retirement with confidence.
- Social Security Claiming Strategies: The optimal strategy will be based upon many factors including the size of your retirement nest egg. There are also some traps to be aware of.
- Managing for total return and the “liquidity bucket”: Beware of an investment strategy that overly migrates toward low risk, fixed interest investments like CDs or bonds to create income. The intent is to preserve principal and live off the interest. However, inflation, longer life expectancies and low interest rates have made this approach impractical for many folks.
Instead, think in terms of continuing a well-diversified “total return” investment approach coupled with a sufficient pool of cash from which to take your income distributions each month and insulate you from market downturns. Harvest the gains from your portfolio periodically and refill the pool as needed.
Tax optimization: Speaking of buckets, take advantage of the different tax buckets found in our tax code.
- Pretax account bucket (traditional IRAs, 401k and 403b accounts): Every distribution in retirement will be fully taxable as ordinary income. Ouch!
- ROTH account bucket: The distributions are totally tax free if done correctly.
- The HSA (Health Savings Account) bucket: Also tax free if used for qualified medical expenses.
- After tax account bucket: Qualified dividends and capital gains get preferential tax treatment and investment losses can be “harvested” and used to offset gains.
There are two ways to maximize your strategy: First, put the right investments in the right bucket. The investments with the highest potential for return belong in the bucket with the best tax treatment. Then take your distributions each year from the tax bucket(s) which results in the best tax outcome.
In a perfect world, you will have all the buckets in place by retirement, but that requires you to start thinking about this well in advance.
Lastly, a few words about cognitive decline. At some point you may experience a decline in your ability or confidence to make optimal money decisions. Take the time during retirement to build a trusted team with which to collaborate and share information to protect your interests, accountant, attorney, financial planner and/or trustees. Bring your children into the mix if possible, so that everyone knows the plan and has visibility regarding decisions and transactions.
Winfred Jacob, CFP®, ChFC®
Senior Financial Advisor
