Retirement income functions much differently from income during your working years. When you were employed, you most likely had a single employer and a single income source. As a retiree, you likely receive income from multiple sources, including Social Security, one or more IRAs, possibly a pension, and an investment account or two.
While working you receive a check on a recurring basis (i.e., every two weeks). As a retired person, you might receive income monthly, quarterly, annually and even sporadically. Add the fact that part of your retirement income will likely come from investments (savings), which you must protect to make them last, and it can all seem confusing.
You have two types of income in retirement: regular and potential. Regular retirement income is like a paycheck. It arrives on a set schedule and will continue for the rest of your life (or as long as you work, if you have a retirement job).
The second type of retirement income comes from savings and investments, including a 401(k) (that you did not annuitize) and an IRA. This is potential income either from regular withdrawals or by taking money out as needed.
First, subtract regular retirement income from essential monthly expenses. These include housing, transportation, utilities, food, clothing and healthcare. If regular income doesn’t cover everything, potential income will be needed. Nonessential expenses – such as travel, eating out and entertainment – come last and are often paid for by withdrawing from retirement savings and investments.
Before taking money out of investments, you need a plan. This is where a trusted financial advisor can help. One common system involves withdrawing 4% of the value of your total cash and investment accounts each year and giving yourself an annual 2% inflation “raise.” You could also take a portion of your savings and investments and buy an immediate annuity to provide continuing cash flow for essential expenses. (For more, see Four Percent Rule.)
Withdraw funds from taxable investment accounts first to take advantage of lower (dividend and capital gains) tax rates. Next, take funds from tax-free investment accounts, followed by tax-deferred accounts such as a 401(k), 403(b) and traditional IRA. Tax-free retirement accounts, including Roth IRAs, should be drawn on last, to allow the money to grow tax free for as long as possible. )
If state or federal taxes are not withheld from some of your retirement distributions, you will likely have to file quarterly estimated taxes. Some states do not tax retirement income; others do. The same goes for local taxes.
Taxable investment account distributions are taxed based on whether the investment sold was subject to short-term or long-term capital gains tax rates. Withdrawals from tax-deferred accounts are treated as ordinary income.
Between 50% and 85% of your Social Security income may be taxable, depending on your total income. Finally, it is almost always best to roll over lump-sum distributions to a tax-deferred account (IRA) to avoid a huge single-year tax bite. (For more, see Tax Strategies for Your Retirement Income.)
Once you reach 70½, you must take a required minimum distribution (RMD) from all retirement accounts except your Roth IRA that roughly equates to your account balance at the end of the previous year divided by your statistical life expectancy. You must take this money out by April 1 of the year following the year you turn 70½. After that, all RMDs are due Dec. 31. Any amounts you take out during the year count toward your RMD. All RMDs are taxable as ordinary income except one from a Roth 401(k) – you have to take out an RMD from a Roth 401(k), but you won't owe taxes on it.
Note: If you're still working at 70½, you don't have to take an RMD from the 401(k) at the company where you are currently employed (unless you own 5% or more of that company). You will, however, owe RMDs on other 401(k)s and IRAs that you own. Depending on your plan, you may be able to import a 401(k) still with a previous employer to your current employer to postpone RMDs on that account.
Your retirement plan administrator should calculate your RMD for you each year, and most will take out any required state and federal taxes and send the balance to you at the proper time. Ultimately, though, the responsibility is yours. Fail to take out the correct RMD and the penalty is a massive 50% of the amount you should have taken but didn’t. (For more, see Understanding Required Minimum Distributions and 6 Important Retirement Plan RMD Rules.)
Managing retirement income is more than receiving the money and using it to pay bills. Some people consolidate their retirement accounts to make management easier. Depending on the nature and features of your accounts, such as fees, this may or may not be wise.In addition, money in a 401(k) may be more protected against creditors than funds in an IRA. Which Retirement Funds Are Protected from Creditors? has the details.
If you use a financial advisor, make sure he or she is from a reliable financial institution and specializes in helping people manage income from a variety of sources. (For more, see Managing Income During Retirement.)