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A successful financial strategy starts with developing a retirement income roadmap for the years ahead. This roadmap has several different moving parts and may seem overwhelming at first. From creating a realistic retirement budget, to deciding how and when you’ll take withdrawals from various accounts, there’s a lot to think about.

Hopefully the following points will help you develop your own personal roadmap, and in turn be on your way to an enjoyable and profitable retirement. Be diligent in planning now, and your golden years will be sweet.

1. Create a budget

The first part of creating your income roadmap starts with deciding how much you’ll need to live in retirement.

Whatever your retirement dreams may be, in order to reach them, it’s crucial to set clear income goals and a retirement budget. The figure you come up with will provide a goal to work toward and help you decide how much you’ll need to save now in order to live comfortably when you stop working.

A good way to start thinking about your income goals is to pretend as if you are retiring tomorrow. How much would your monthly check need to be? You could state your goal as either a sum of money or as a portion of your salary.

To come up with this figure, start with your basic monthly living expenses, including food, shelter, utilities, clothing, taxes, insurance, transportation. Also be sure to factor in the costs of any family members who depend on you, as well as the rate of inflation, which has averaged 2.5% over the past 20 years.

Some of your expenses may decrease in retirement if your mortgage or other debts are paid off. But keep in mind with the extra time on your hands you’ll probably want to have more income for travel and leisure activities. Try to set a realistic budget based on you discretionary income will allow you to enjoy your well-earned freedom.

Also remember that when you hit your 70s and beyond, you will likely be spending more on healthcare, which can have a substantial impact on your retirement savings. Be sure to factor in a cushion of funds that will cover such expenses.

2. Choose which income streams to use first

After you’ve set a retirement budget, it’s time to decide the order in which you’ll use certain income streams to sustain you through your golden years.

I recommend tapping into deferred income sources first. These include Social Security funds and monthly pensions. Once you reach full retirement age (66 for those born between 1943 and 1954; and 67 for those born in 1960 or later), you’ll automatically receive checks from these sources. Since you’ll already be paying taxes on this income, there’s no need to dip into other retirement accounts unless it doesn’t cover all your expenses.

3. Create a strategy for investment account withdrawals

For many retirees, living on deferred income simply isn’t sufficient, in which case you should develop a plan for how you’ll supplement those funds with withdrawals from other accounts.

Try to abide by the following methods when deciding which funds to access first and how much to withdraw:

4 Percent Rule

It’s a good idea to withdraw a maximum of  4 percent annually from a particular retirement account. This percentage will hopefully provide a steady stream of funds to cover expenses in retirement. It also allows funds to be withdrawn for a number of years from that account. The 4% rate is considered a “safe” rate, with the withdrawals consisting primarily of interest and dividends.  

The 4% rule stems from a 1994 study by financial planner William Bengen. After testing a variety of withdrawal rates using historical rates of return, Bengen found that 4% was the highest rate that held up over a period of at least 30 years.

You can carry this rule out by annually withdrawing 4% of the value of all your investments that are designated for retirement funds. In order to reflect the impact of inflation, however, you would increase the dollar amount of your first withdrawal in the following years.

Some experts argue that an initial withdrawal rate closer to 3% may be more appropriate for those that want their retirement investments to sustain them for at least three decades.

If your budget calls for less than 4% annually, then that’s obviously a good thing. But if it calls for more than 4% of your retirement funds, it’s time to go back and trim your budget. In the end, it’s a good idea to work with a trusted financial professional to decide a percentage amount that is right for you.

Tap into taxable accounts first

If you’re withdrawing funds for retirement before you reach age 70 ½ and have to take Required Minimum Distributions (RMDs), you should consider withdrawing money from taxable accounts first. These include investments like stocks, bonds, mutual funds, and real estate. You already have to pay taxes on these every year, so why not go ahead and take the money?

Tapping into these sources first will also give other accounts, such as IRAs and 401(k)s, more time to grow in a tax-free manner. As a general rule, it’s good to delay tax payments for as long as possible.

A stock that sells with a capital gain from a taxable account incurs a capital gains tax. It’s usually taxed at a lower rate than ordinary income tax rate. On the flip side, the same appreciated stock withdrawn from a traditional IRA may be hit with a steeper tax rate. This is because all withdrawals from the IRA are taxed as ordinary income.

Access tax-free accounts next

Tax-free accounts include tax-free municipal bonds and Roth IRAs. Because you’ve already paid taxes on the money in a Roth IRA, you can receive the full value of the account, including investment earnings, without having to pay taxes when you withdraw the money. The two stipulations are that the Roth has been open for at least five years and you’re age 59 1/2 or older.

Roth IRAs have the added advantage of not having RMDs. So there is no particular age in which you’re required to take withdrawals.

When you leave such contributions untouched for as long as possible, they can grow and compound without any tax implications. They can also be easily passed on to heirs. 

 Withdraw from tax-deferred accounts last

Tax-deferred assets include traditional IRAs, 401ks, and annuities. These should be accessed once you’ve used up most of your taxable retirement money, as well as tax-free accounts.

If you are past age 59 ½, you’ll avoid any early withdrawal penalty when you access these accounts. Remember, as previously stated, the withdrawals themselves from these accounts typically are taxed as ordinary income. By waiting to withdraw money from these accounts, you receive more tax-deferred growth.

You may want to delay withdrawals from annuities in particular as long as you can, because the older you are when you start your payouts the greater your payout amount will be, although it will also be taxable.

Which investment vehicles are the ‘most’ income friendly?

There are so many different retirement investment options, sometimes it’s hard to figure out which ones are the most advantageous from an income standpoint. Following are some of the best choices:

1. Dividend stocks/mutual funds/ETFs

Dividend stocks can be especially beneficial if you’re investing for the long-term. Dividends can make up around 45% of your total return if you re-invest. (Total return calculates dividend payments.) Dividends are less volatile than earnings over time.

Investing in mutual funds is highly beneficial. You will receive a professionally diversified portfolio for much less money than it would take to purchase individual stocks and bonds. Your fund manager is also responsible for tracking the performance of all the funds so you don’t have to worry about the details.

Exchange-traded funds (ETFs) take the benefits of mutual fund investing to the next level. Advantages include low operating costs, flexible trading, greater transparency, and better tax efficiency in taxable accounts.

2. Annuities – Fixed and Variable

An annuity is an insurance product that pays out a steady income stream in retirement. It’s meant to be used as one part of a strategic plan for your golden years that can be mapped out with a professional.

Here’s how an annuity works: you make an investment in the annuity, and it then makes payments to you on a future date or series of dates. You can decide if your annuity payments will come monthly, quarterly, annually, or even in a lump sum.

Annuities are beneficial because they carry a low amount of risk, and they can be often be protected from creditors and frivolous lawsuits.

Tax deferral and exclusion ratios on annuity payouts are additional strategies that help people lower their tax exposure. Annuities can also efficiently pass outside of probate, so they are beneficial from an estate-planning standpoint. 

3. Bonds – Municipal, Corporate, and Agency

Decades ago, U.S. savings bonds were issued on paper. They were a popular way to make a contribution toward a child or grandchild’s future. They are now issued electronically and are not nearly as widely used as before. But bonds can still be valuable components of retirees’ savings portfolios.

The “cash infusion” from cashing in a bond may help some retirees delay withdrawing assets from other accounts. This allows them to continue growing. A bond that is decades old could cash out at anywhere from three to nine times its face value at full maturity. Also, the interest on bonds is exempt from state and local taxes even though it is taxed by the IRS.

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems, and many other projects for the public good.

When you purchase a municipal bond, you are lending money to a state or local government entity. It then promises to pay you a specified amount of interest and return the principal to you at a specific maturity date. 

Agency bonds are issued by two types of entities: Government Sponsored Enterprises (GSEs), usually federally-chartered but privately-owned corporations; and Federal Government agencies. The latter may issue these bonds to finance activities related to public purposes. These include increasing homeownership or providing agricultural assistance.

Agency bonds are known as relatively safe investments, with low risk and high liquidity. They give individuals and institutions the opportunity to gain a high return on their investment. They also sacrifice very little in terms of risk or liquidity. Also, the multitude of bond structures found in agency offerings allows buyers to tailor their portfolios to their own situations.

Corporate bonds are also attractive to investors for a number of reasons. They usually offer higher yields than other maturity government bonds or CDs. They also provide steady income while preserving your principle; there are several options for “safe” investments in terms of the likelihood of repayment of principal and interest. Corporate bonds additionally offer diversity in their options. They are also very marketable if you need to sell them before maturity.

4. CDs

CDs (or share certificates, as they’re called at credit unions) are a way to enjoy higher returns on your money without a lot of risks.

You agree to keep your money in a CD for a designated period of time, called the “term length.” Generally speaking, the longer the term length, the higher the interest rate you’ll earn.

The average rate on a three-year CD taken out at a bank currently stands at 0.49%. However, many credit unions and online-only banks offer certificates with rates above 1%.

Other advantages of CDs include having your savings—up to $250,000 per account ownership category per institution—insured by the federal government.

Also, since CDs have an early withdrawal penalty like IRAs and 401(k)s, there is more of a savings incentive than a typical checking or savings account.

BONUS:  Withdrawal tricks and tips you need to know

1. 72(t)

A special IRS rule called a 72(t) allows you to take money out of your retirement plan before age 59 1/2 without paying the 10% “early withdrawal” penalty.

A 72(t) is accomplished by the following steps: Decide what age you would like to completely stop working; roll your 401(k) over into an IRA; apply for a 72(t); choose one of three optional payout amounts offered by the IRS; receive a designated income stream of “substantially equal periodic payments.” When your 72(t) has been satisfied you are eligible to withdraw any amount from your IRA.

Payout options are based on your age; the age of your beneficiary; the amount of money you have in your account; percentage rate used for the calculation; and how long the IRS’ mortality table expects you to live.

The main thing to remember with a 72(t) is that you must take substantially equal periodic payments according to schedule. Otherwise the IRS may subject you to a 10% penalty plus interest on all distributions already made. The IRS does permit you to make a one-time change to your distribution method without penalty.

2. Net Unrealized Appreciation

Let’s say you’re nearing retirement and your tax-deferred employer-sponsored retirement plan stock has appreciated significantly. A net unrealized appreciation tax treatment (NUA) could save you a bundle in taxes.

Net unrealized appreciation is the difference between the price you initially paid for the company stock (cost basis) and its current market value.

Most types of assets transferred from an employee-sponsored retirement plan to a taxable account are taxed on current market value. Instead, request an in-kind distribution of some or all of your employer stock as part of a lump-sum distribution. Then, you’ll pay income tax only on the stock’s cost basis. You won’t be responsible for the amount it increased since you purchased it. That’s where the major tax savings comes into play.

With NUA, the shares of your company’s stock are held tax-free in a non-qualified brokerage account. When you sell the shares, you’ll only be required to pay long-term capital gains tax on the stocks’ NUA. The maximum federal capital gains tax rate is currently 20% (plus 3.8% for the Medicare surcharge). That is considerably lower than the 39.6% top income tax rate. Any funds outside your in-kind distribution can be rolled over to a tax-deferred IRA.  

Important note: A 10% penalty may apply if you are younger than age 59½ when you take the in-kind stock distribution from your 401(k).

3. The Age 55 rule

Fifty-five could be the magic number for you to access your company retirement plan. Penalties may not apply if you were terminated or resigned from your job at that age or older.

This exception is sometimes called the “Age 55 Rule.” Remember your 401(k) distribution will still be subject to federal income taxes. 

The age 55 rule only applies to employee-sponsored retirement plans–not IRAs. Let’s say you roll over your company retirement plan to an IRA. If you take withdrawals from that account before age 59 1/2, you’ll still have to pay a 10% penalty. The penalty is sometimes waived if there’s an extenuating circumstance, or you use a 72(t). Once you roll over your company plan money to an IRA, you can’t go back and use the age 55 rule.

The bottom line

Turning your retirement assets into sustainable income is a lengthy and complicated process. But the rewards for your diligence are plentiful. A financial expert can guide you through the process. He or she will help you develop your own personal roadmap to sustain you for the years ahead.

Remember the secret to making your nest egg last is not necessarily how much you’ve got. It’s how well you plan your income strategy. Start taking the steps today toward a more secure and fulfilling future. See below for a graphic illustration of everything we just covered:

How to Create a Worry-Free Retirement preview

Author Ron L. Brown, CFP®

Ron is a CERTIFIED FINANCIAL PLANNER™ and President of R.L. Brown Wealth Management. He specializes in retirement, estate, and business planning for professionals and entrepreneurs. Ron assists his clients with creating a financial plan to ensure they are able to live their ideal lifestyle during retirement and leave a strong legacy for their family. Ron has been featured in The Wall Street Journal, US News, Yahoo Finance, Investopedia, and numerous other high profile financial publications.

More posts by Ron L. Brown, CFP®
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