^{Episode 3}
You Don't Retire on Assets. You Retire on Income.

Welcome back to The Retirement Game Plan. In our most recent episode, we talked about the process of retiring, or how we go about retiring. Today we're going to jump into some more specific items, and there's one really important truth when it comes to retirement. That's that you don't retire on assets. You retire on income.

So the real question becomes, where does that paycheck come from? Because in retirement, you no longer have the employer paycheck every couple of weeks showing up in your bank account. You've got to create that income out of the assets and resources you have, and you're the one responsible for creating it.

I want to cover three different topics in today's show. The first is income layering, or what the different sources are that you could potentially draw income from. The next is withdrawal order. You may have different types of accounts, so where do we pull from first? And the third, a really important one for retirees, is sequence of returns and the impact that can have on your retirement plan. If you find value in what I share today, take this show and pass it on to somebody getting ready to head into that stage of life, so we can help them be better prepared for the journey they're about to go on.

So let's dive into income layering. In retirement, most people are going to have multiple sources of income that replace the salary they used to get from their employer. You typically have to coordinate those to get to the amount of dollars you need to live the lifestyle you deserve.

The first source is Social Security, a foundational income source for most everyone retired today. If you've paid in over the years, you've earned some sort of benefit. There's a lot of talk about Social Security going away or being reduced, and who knows what that future is. I talked about it in episode two, that I'd be really surprised if our political officials ever decided to completely get rid of Social Security. But it's an extremely important part of most people's retirement plans, and what I find happening more and more is that people are making bad decisions when it comes to the timing of when those benefits start.

Where does that come from? Oftentimes it's from a coworker, or those water cooler experts who say you need to turn it on as soon as you can, because what if you were to die and you don't get all your money? There are a lot of different factors that go into that, and I'll dive into it another time. But the decision does matter, and the one piece I'll leave you with is that for every year you delay between age 62 and age 70, there's an eight percent adjustment or increase in those Social Security benefits. Nowhere else that I'm familiar with can you get eight percent guaranteed growth on your income in the world we live in.

Another key component on Social Security is the married concept. When one of you passes away, the remaining spouse gets to keep the higher of those two benefits. We'll talk more about that as the show goes on, but I truly believe it's pretty important. One of the pieces of advice I always give our clients is to max out one of the two benefits and maybe turn the other one on earlier. A lot of factors go into that decision, but Social Security is very much a common income source for retirees today.

The second source might be a pension from your employer. We've talked about that in the last couple of shows. With a pension, you have to make the proper election, similar to Social Security timing. What's the best election for you and your situation? Whether it's a lump sum that you roll over and take control of, a lifetime income only for you, or some sort of survivor benefit for you and your spouse, those are key decisions that can make up quite a bit of your guaranteed monthly income. And as I talked about in episode two, circumstances matter there too. It may not just be about the most amount of money. It may be about what you want that money to do for you.

The third most common source is your portfolio: your 401(k) plans, your IRAs, your Roth IRAs. You've thrown all that money together and built up this pile that now we have to draw from. The key here, in my opinion, is that you need structure. You can't just guess or pull those dollars out willy-nilly. Oftentimes these dollars are used more for lifestyle or fun money, the pull for a trip or to cover the golf membership at the end of the year. But we want to be strategic in how you position those assets to prepare for whatever circumstances may come down the road.

The final income source, and not everybody has this, is more of your guaranteed income. Whether that's rental income, the sale of a business you ran, or a pension-like income you've created out of the portfolio using some sort of annuity contract. The goal we always take on in helping our clients plan is to generate guaranteed income high enough to cover your fixed expenses. Those are the things that will never go away: your insurance premiums, your utility costs, your taxes, putting food on the table. If we can create a guaranteed income stream high enough to cover those, it puts you in a much more flexible and enjoyable position, because you know those needs are covered on a regular basis.

The key takeaway from income layering is that we really want a plan that coordinates how much you're drawing from each source and aligns with the needs we've determined in your retirement plan. You want your income to be as predictable as possible, you want stability inside that plan, and you want a structure that's easy to understand, easy to manage, and provides some of that comfort our clients always talk about wanting.

Now let's move on to why withdrawal order matters. This is a commonly overlooked area. When people approach retirement, they're often not certain where they should take their money from. They may be taking it out of their cash or checking accounts, or taking it all out of the 401(k) and creating tax issues they didn't even realize they were going to run into.

There are three common account types I want to talk about, and I'm going to keep it fairly general. The first is your taxable accounts. These are your checking, savings, CDs, maybe a joint brokerage account or an individual brokerage account. These are the accounts where every year you get some sort of 1099 or tax document saying you've made so much in interest or capital gains. When you withdraw from these accounts you may have some tax consequences and capital gains, but not as significant as what you'd run into with the second source.

That second source is your traditional pre-tax accounts: 401(k)s, traditional IRAs, and annuity type plans. When you pull money from those, that amount gets added to your ordinary income tax. It goes to your adjusted gross income and into a lot of calculations we'll get into down the road. The third account type is your Roth or tax-free accounts. These are the portfolios where, if you pull money out, you have no tax consequence, because you paid the taxes before the money went in.

Those are the three most common account types. The general rule of thumb, if you did any Google research on which accounts to take money from first, would recommend taking them in the order I just shared. Take from your taxable accounts first, let the pre-tax accounts grow as long as they possibly can, and let the Roth go as long as possible. I don't necessarily agree with that all the time, because I believe we're in the lowest tax rate environment we've been in as a country in well over a hundred years. So I typically look to help our clients optimize their tax situation and strategically pull from the accounts we need to in order to do that.

Other things come into play too, like your required minimum distributions, or RMDs as they're often called. This is an often overlooked planning scenario. If you're 55 years old and you've got a significant amount of your nest egg in pre-tax accounts, at age 75 the government will force you to take withdrawals and pay income tax on those portfolios, because you haven't yet paid that tax. And surprisingly enough, the government would really like you to pay some tax on those dollars. So it's important to plan ahead and look forward. Paying tax at a twelve percent rate might be more efficient than delaying those withdrawals until you're forced to take a larger amount and may have to pay at a twenty-four percent rate.

Other things out there are your Medicare premiums. If we hit a certain threshold, there's something called IRMAA, the Income Related Monthly Adjustment Amount. If we make too much money or have too much taxable income, now we have to pay more for our Medicare costs. So there are all these things we have to think about in deciding where we're going to pull money from, and that's why withdrawal order matters.

There's one really important concept here, and I'm going to share a story that's close to home. I call this the widow's tax trap. A lot of you may know this, but for those who don't, I lost my dad last year. Mom and Dad had done an incredible job of building a nest egg and businesses, and I got the pleasure of working with them here in our office for the last twenty some years. They had just retired. We had built most of their plan around both of them living into retirement for the foreseeable future.

But when Dad died, we ran into an immediate concern, and that was the fact that Mom would now be on a single filer return instead of married filing jointly. Not a lot of people have ever looked into that, but the amount of income a couple can generate is taxed at a lower rate than what a single filer can. So when you're thinking through when to pay that tax, don't get caught up in the trap of only deferring things out as long as you can, because if one spouse dies, the other may be left paying those taxes at a much higher rate. Let's face it, if one spouse dies, income often stays very similar. Lifestyles don't change. Travel plans may change a little, but not much. So we really need to be strategic about where we pull those dollars from and when.

Another big concept that goes into that is the Roth conversion. I don't want to get into the details today, because that will probably be an entire show at some point down the road. But going back to optimizing that tax plan, it may include converting some of your pre-tax money over to Roth money so you can control the tax rate that's going to be paid.

Finally, let's talk about sequence risk and protection of the plan. I think this is fascinating information, and not a lot of people realize it. Most people don't realize that market losses have far more impact on a distribution plan than they do on an accumulation plan.

So what do I mean by that? As long as we're saving and not taking any money out of a portfolio, the order of our returns over a set period doesn't really matter. If I get certain rates of return every year for ten years, at the end of that ten years the average rate of return will be the average rate of return, and the portfolio value will end up the same regardless of what order those returns came in.

But in distribution, it's an entirely different story. Let's tell a little story here and see if it resonates. Assume we've got a million dollar portfolio, and after all the planning work we've done, we determine we want to take a four percent withdrawal. We won't get into the whole debate about what a safe withdrawal rate is today, but let's assume four percent. So we pull four percent out of a million dollars, which is forty thousand dollars. Let's assume that happens on the first day of the year. After the withdrawal we have nine hundred sixty thousand left. The markets go down significantly that year, and at the end of the year our portfolio is worth eight hundred thousand.

Imagine sitting in the chair and saying, okay, we need to take our withdrawal for the following year. How much would we like to withdraw? We're only taking four percent of the portfolio, but four percent of eight hundred thousand is now only thirty-two thousand. Or are we going to sit there and say, you know what, I'd rather have that forty thousand we had planned for? Of course you're going to take the forty thousand. But now the impact is that we've taken a five percent withdrawal from our portfolio, not a four percent withdrawal.

Do you see where that impact could make a difference? That following year we took five percent, not in line with the plan we developed going into retirement, but market volatility is forcing our hand. That's where you've got to be careful. In a distribution plan, if you have a bad run of two or three years of down markets, you could really impact the value of that portfolio at the end of that same ten year period.

So how do we manage it? How do you approach sequence of returns risk? The first option, and nobody ever really likes this one, is that we reduce our spending. We could say we're always going to take four percent, so whether that's forty thousand or thirty-two thousand, that's what we take. But then we've got to cut eight thousand dollars out of our budget, and most retirees don't want to do that.

We can use a buffer approach, which is often what we utilize with our clients. We allocate some short term money, some intermediate term money, and some long term money, and we take a lot of the risk off the short term bucket, with the intent that that's where we pull the forty thousand from. It may not have a lot of fluctuation in value, but we know it's protected against market volatility and can provide the income stream we need. The other option is a more structured withdrawal plan, maybe utilizing products like annuities, or going back to some of those pension decisions, where we know that forty thousand is going to be guaranteed through the benefits the product provides.

Whatever strategy you take on, it's really important to know that as you go into retirement, you can't just leave all the money sitting in an S&P 500 portfolio and not account for that additional risk. If we see a two or three year downturn in the markets, which we have no control over, we may be putting our ability to know that money will be there at risk.

So how do we bring all this together? In a plan, your income needs to be coordinated. It starts with what we talked about in episode one, determining how much money you need. Then we've got to go find where those dollars are going to come from. It may be a combination of any of the four sources we talked about earlier in the show, but we need to coordinate all of it. We need to protect against risk: sequence of returns risk, longevity risk, inflation risk, all those things. And we also need to be tax aware. What are the tax consequences if I take money out of certain accounts?

When it isn't planned, income just becomes reactive. It becomes rash decisions that often lead to worse consequences, let alone the stress and anxiety that creates. So making sure all of that is organized is really my message today. Address the risk, plan for the taxes, and make sure you've coordinated those income streams to get you to a successful retirement.

I'd leave you with this. The one thing I want you to take away is that it's not about the assets you have, it's about the income they can generate. I use this story quite often with clients. It's an old one, and I mentioned Tom Hegna in a prior show, but I picked it up from him. He said that oftentimes it's not the value of the cow that's important, but the amount of milk that it produces that you should really care about. Retirement planning is a lot of that same approach. It's not about the size of the portfolio, it's about the income that portfolio can create for you.

So in conclusion, the question I'd leave you with is this: can you clearly explain where your retirement income will come from? And do you have a plan coordinated to generate the most efficient income streams possible in your retirement? If not, go put together the plan, find an advisor, give us a call. We'll figure it out one way or the other. I appreciate your time. I hope this helps you understand the importance of planning, and now go out there and be great.