Often you hear retirees talk about living on a “fixed income.” And while you may think you are currently living on a fixed income, because you know what your salary is (including the occasional bonus and raise), that is far cry from what a retiree faces. Yet just as a person in his or her working years needs to budget and plan in a smart way, so do almost all retirees. But there is more at stake when you retire because the word “fixed” takes on a much more dramatic meaning.
If retirement is around the corner (or if you’re just thinking way ahead), there’s no reason to look at a fixed income in retirement as a bad thing. It just takes some adjusting—which is something you’ve already been doing for years to make the most of the money you earn.
Start by looking at potential sources of retirement income.
There are several ways you can generate income during your retirement, including:
- Investments. You can generate an income stream from:
- Interest paid by bonds (some bonds generate tax free income. Note: A substantial portion of income will be exempt from federal income tax, but income may be subject to local or state income taxes and the federal alternative minimum tax or AMT. Capital gains, if any, will be taxable.)
- Stock dividends
- Scheduled payments from variable annuities
- Sell some of your securities and use the proceeds as income
- Tax-deferred retirement accounts. Some experts recommend a withdrawal rate of 4% per year from retirement accounts such as 401k plans and Traditional IRAs. But everyone’s situation is different. The amount you can withdraw depends on the amount you’ve saved, how much it is earning and how long you need it. Plus you must consider the income taxes that have to be paid at the time of withdrawal.
- Tax-free accounts. If you have money in a Roth IRA or Roth 401k that money comes out income tax-free1.
- Taxable products. You may also have some money in standard taxable products like bank CDs and mutual funds. There's no reason why these products can't add to your income.
Fixed income? Says who?
Once you’ve determined your sources of retirement income, consider withdrawal strategies that can help make your money last longer. For instance, there’s no reason you have to withdraw the same amount every year.
An example: you may want to withdraw more during the early part of your retirement, when you’re more active and perhaps want to travel or play more golf. Later in retirement, when you’re more inclined to kick back and relax, you may need less income to support your lifestyle. Or you can do just the opposite—take it easy on the withdrawals in the early years, maybe even supplement your income with a part-time job. Then, as you feel more comfortable about your income stream, you can gradually ramp up your withdrawals. Medical expenses tend to increase with age, so this is a smart approach for many people.
Getting your retirement ducks in a row
If you’re not concerned about leaving money to heirs (lucky you!), many financial professionals recommend that you spend down your accounts in this order:
- Tax-free accounts (such as Roth IRAs)
- Taxable products (such as bank CDs)
- Tax-deferred accounts (such as your 401k and traditional IRA)
Following this order postpones paying income taxes and keeps more of your money potentially growing tax-deferred. It may also help you manage your income tax bracket and thus reduce the total amount of retirement income that you pay towards income taxes. Just remember, you must begin making Required Minimum Distributions (RMDs)—and paying taxes on the withdrawals—from Traditional IRAs and 401ks by age 70½. Failure to do so, or taking less than the correct RMD, can lead to heavy penalties. And that means even less money for you.
You may be able to enjoy a long, fulfilling retirement on a fixed income, as long as you’ve fixed a retirement withdrawal strategy that meets your needs. A financial professional can help you get it sorted out now, so you won’t have to worry about it later.
1Distributions from a Roth account are federal income tax free as long as the criteria of a “qualified distribution" is met (as long as you've satisfied the 5 year holding period; and are age 59 ½ or older, disabled or deceased).
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