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—such as 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 likely will come from investments (savings), which you must protect to make them last, and it can all seem confusing.
- There are two types of retirement income—regular and potential. Potential retirement income can include IRAs, 401(k)s, and reverse mortgages.
- There are four types of regular retirement income, including social security, defined-benefit pension, annuitized defined-contribution plan pension, and employment.
- Managing cash flows and withdrawals are important parts of retirement planning, which includes budgeting for expenses and having a plan, such as the 4% rule, in place.
- Taxable investment accounts should be tapped first during retirement, followed by tax-free investments, then tax-deferred accounts.
- At 72, you must take required minimum distributions (RMDs) from all investment accounts except Roth IRAs.
Regular Retirement Income
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.
Social Security: This government pension program makes up a significant part of regular retirement income for many people. It is based on your earnings during your working years and distributed to you monthly. Social Security gets adjusted annually for inflation, so the amount you receive will go up each year.
Defined-benefit pension: A defined-benefit plan, similar to Social Security, offers regular monthly lifetime income based on your earnings during your working years. These traditional pension plans are increasingly rare, but some people are lucky enough to have one. Most people who retire from a job that offers a defined-benefit pension take their money in the form of an annuity.
Annuitized defined-contribution plan pension: Defined-contribution plans—401(k) plans, for example—are much more common these days than traditional pensions. Some employers allow retiring workers to annuitize their defined-contribution plan to produce a lifetime income stream such as that from a defined-benefit pension. Annuitizing frees you from making investment decisions and provides a regular income for life, but it often comes with high fees and little or no inflation protection.
Employment: Working full- or part-time in retirement is one way you can increase the amount of your regular retirement income. It isn’t for everyone, but some people see both social and financial benefits by remaining in the labor force.
Potential Retirement Income
The second type of retirement income comes from savings and investments, including a 401(k) and an IRA. This is potential income either from regular withdrawals or by taking money out as needed.
Tax-advantaged accounts: Your employer may allow you to take your defined-benefit or defined-contribution plan funds in a lump sum. You can roll the funds into an IRA to defer taxes until the money is withdrawn or pay the taxes and access the funds immediately. You also may leave a defined-contribution plan in place. In all cases, the money is typically invested.
Investment and savings accounts: You may have one or more taxable investment accounts that can be a source of income as needed. And, one hopes, you also have an emergency fund with three-to-six months of monthly expenses that you may draw on as needed.
Reverse mortgage: A reverse mortgage allows you to convert home equity to a loan. You can take the proceeds in a lump sum (to invest), a series of regular payments, or a line of credit. Because it is a loan, the money isn’t taxable. Important to consider though is that you must repay the loan when you die or sell your home.
Cash Flow and Timing
First, subtract regular retirement income from essential monthly expenses including housing, transportation, utilities, food, clothing, and health care. If regular income doesn’t cover everything, you may need more income. 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 from investments, you need a plan. This is where a trusted financial advisor can help. One common system, the 4% rule, 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.
Order of Withdrawal
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)s, 403(b)s, and traditional IRAs. You should draw on tax-free retirement accounts, including Roth IRAs, last to allow the money to grow tax-free for as long as possible.
If the state or federal taxes are not withheld from some of your retirement distributions, you likely would need to file quarterly estimated taxes. Some states do not tax retirement income, while 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. Finally, it is almost always best to roll over lump-sum distributions to a tax-deferred account to avoid a huge single-year tax bite.
Between 50% and 85% of your Social Security income is taxable, depending on your total income.
Managing Required Minimum Distributions (RMDs)
Once you reach 72, you must take a required minimum distribution (RMD) from all retirement accounts except your Roth IRA. The amount of distribution must roughly equate to your account balance at the end of the previous year, divided by your statistical life expectancy. The RMD age was previously 70½ but was raised to 72 following the December 2019 passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act.
You must take this money out by April 1 of the year following the year you turn 72. 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 those from a Roth 401(k)—you do need to take out an RMD from a Roth 401(k), but you won't owe taxes on it.
If you're still working at 72, 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.
If you fail to take out the correct RMD, the penalty is a massive 50% of the amount you should have taken but didn’t.
The Bottom Line
Managing retirement income is more than receiving the money and using it to pay bills. Some people consolidate their retirement accounts to make it easier to manage them. 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.