At some point in our lives, we all need to plan for income in retirement. For many, this means understanding how to move from the accumulation phase, where we are working and saving for retirement, to our decumulation phase where we use our savings to generate retirement income.
Of course, no one is forcing us to make a plan, but failing to do so could lead to several undesirable outcomes, ranging from underspending and lower quality-of-life to spending too much, overpayment of taxes, and the possibility of running out of money completely.
The goal of our plan is to be reliable, to meet our retirement goals, and to be tax efficient. However, this is easier said than done and there are quite a few risks, unknowns, and complexities. The main problem is the length of time that the retirement plan needs to cover. Typical retirements last between 20 and 40 years, and no amount of planning can make up for the fact that no one knows the future.
Retirement Risks
Given the unknowns involved, understanding and managing risk will be a big part of our plan. These risks can come from many areas, including:
- Economic market risk, especially sequence-of-return risk, where the market goes through an extended period of low returns.
- Spending risk, where we spend too much from our portfolio.
- Longevity risk, where living longer than planned strains our portfolio and adds risk to our retirement income.
- Health risks, which may unexpectedly change our assumptions about spending and qualify-of-life.
- Governmental, legal, and tax changes, which may also change assumptions about our plan.
Of these risk areas, spending risk is the only one we can directly control because it comes about directly as a result of our actions. The question for us is: should I increase spending to meet my goals and improve my quality-of-life, or do I make do with less income and reduce the risk of running out of money? This is a highly individual question that depends on our circumstances.
At first, it may seem wise to take the conservative approach and make do with less income. After all, running out of money could be pretty dire. However, the unknown future means that there is always some risk in our lives, and running out of money isn't the only risk. For example, there is also the risk that health issues may shorten our lives or our ability to do the things we want in retirement. Overly conservative approaches to spending in retirement may result in leaving a larger estate to our heirs rather than meeting our own goals while we're still living and healthy.
Bonfire Planner focuses on helping you plan the income you need to meet your goals with a level of risk that makes sense to you. We think the right question is: what are my goals and what level of spending risk is reasonable? We're willing to take risks to achieve our goals, but we want to understand the amount of risk we are taking.
Three Retirement Income Strategies
Your retirement income can come from many sources, including:
- Social Security, pensions, and annuities.
- Your retirement savings in retirement accounts such as IRA and 401k accounts (both Traditional and Roth).
- Regular taxable brokerage and savings accounts.
- Business and rental property income.
- A part-time job.
Vanguard's paper From Assets To Income describes three approaches for turning your retirement savings into a reliable source of income in retirement:
Dollar Plus Inflation
With this approach, you start with choosing a fixed dollar amount (based on a percentage of the portfolio) in the first year of retirement and increase by the inflation rate in subsequent years. The dollar-plus-inflation strategy is described in the Trinity Study and the 4% Rule.
Percentage Of Portfolio
Percentage-of-portfolio is a simple strategy where you withdraw a fixed percentage of the portfolio each year. So if the market goes up, your income increases, but if the market goes down, your income will decrease.
Dynamic Spending Rule
Dynamic-spending is similar to the percentage-of-portfolio approach, but a ceiling and floor are applied each year to help smooth out the impact of market fluctuations on your income.
Which one should you choose? We think that flexibility is a powerful tool for managing risk. If we can be flexible in the amount of income we need each year, we can take on more risk (and more income) because we'll have the ability to course-correct and take a lower amount in future years if needed. As a result, we think dollar-plus-inflation is likely a better approach for people with less income flexibility, and that dynamic-spending or percentage-of-portfolio are good choices for those with more flexibility.
Taxes In Retirement
Nobody likes paying taxes, and most of us trying to avoid paying them for as long as possible. Sometimes this strategy works, but often it will just lead to a higher tax bill in the future. Planning can help us to avoid making mistakes that lead to large tax bills.
Basics of retirement tax planning include:
- Projecting income into the future to determine the potential future impact of Social Security and required minimum distributions from tax-advantaged accounts.
- Taking advantage of lower tax brackets when available.
- Considering the impact of Roth IRA conversions.
- Taking advantage of tax-loss harvesting and tax-gain harvesting when those opportunities are available.
Many of us have grown accustomed to maximize our tax-deferred accounts while working as a strategy for reducing taxes. However, in retirement, we need a different mindset. We need to understand how we'll spend down our tax-deferred accounts in the most tax-efficient way possible. Failing to do so can cause large, surprising tax increases for us in the future when RMDs start.
We created Bonfire Planner to measure the risk of thousands of potential retirement plans, and to present to the user the best, most tax-efficient options grouped by risk level.
You can install the app on your iPhone or iPad in the App Store. You can reach us at support@bonfireplan.com with any questions or comments, or on Twitter at @bonfire_plan.
- Scott
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