How Retirement Cash Flow is Different from Working Income
By Zeke Anders on August 29, 2023
It can be unnerving to go from receiving regular paychecks or business income to relying on a pool of assets to generate cash flow. Retirement cash flow is inherently different from receiving a salary. There are many more variables to consider and degrees of freedom available. There are additional challenges as well as opportunities. A few key differences are withdrawal of a finite resource for an unknown length of time, variability of the asset base, different layers and sources of income, and greater control and complexity of taxes. The goal of this piece is to provide a breakdown of these different variables to show that while there is a lot to consider there are opportunities as well.
Withdrawal of a finite resource for an unknown length of time
In our working years, we don’t know how many working years we have left or what our salary/income will be over those years, but we have some confidence that the next paycheck is coming. In retirement, however, we start with a pool of assets and have to determine how to spread that over an unknown number of years. That might include a legacy goal as well. Charlie Munger, the Vice Chairman of Berkshire Hathaway and Warren Buffett’s longtime business partner and close friend, once said “All I want to know is where I’m going to die so I can never go there.” That would be helpful, but in the absence of that information, it would even be helpful just to know when you’re going to die. With that information, it would be much easier to create a retirement income or decumulation plan. Since we don’t have that knowledge, however, we have to use probability and judgement to estimate the length of our retirement. Most people don’t have enough assets to fund all of retirement simply with cash or short-term bonds. As such, we need to invest in more riskier assets such as long-term bonds and equities for the potential growth they provide. These risky assets introduce the next difference between retirement income and working income, which is a fluctuating asset base.
Variability of the asset base
Investing in risky assets means that the value of our savings, our asset base, will fluctuate over time. On the other hand, our essential spending needs are more consistent. This introduces sequence of returns risk. As an example, if your portfolio balance is $2 million, and you plan to spend $80,000 this year, that is a 4% withdrawal rate. Let’s say you plan to spend the same amount next year, but your portfolio has grown to $2.2 million. Now, $80,000 is only a 3.6% withdrawal rate. That is a more conservative withdrawal rate than 4% and increases the probability of meeting your goals. If the portfolio decreased to $1.8 million, however, now $80,000 is a 4.4% withdrawal rate, which slightly increases the risk of not meeting your goals. Research shows that based on historical U.S. stock and bond market returns; a 4% withdrawal rate from a portfolio of 50% stocks or greater would have supported a 30-year retirement in most periods. The 4% withdrawal rate only applies to the first year, and that same amount is simply adjusted for inflation each year thereafter. The research also found that the periods with the lowest safe withdrawal rate didn’t necessarily have the lowest average returns, but they had mediocre or negative market returns in the early years of retirement. Low returns early in retirement increase the withdrawal rate for the same dollar amount of spending, which leaves fewer assets to participate in a market recovery. As the retirement window shrinks, the amount of future withdrawals also shrinks and low market returns at the end of retirement are not as harmful. An important point is that the research showed an allocation of at least 50% to equities to was necessary to achieve the 4% withdrawal rate. While traditionally “safe” assets such as short-term treasury bills are not subject to as much price volatility as equities, the returns are simply not high enough to compensate for inflation and 30 or more years of withdrawals. Most retirees will need to take some risk via equities for the potentially higher growth they provide. One thing to remember, however, is that the portfolio is not the only source of income in retirement, which is our next difference.
Different layers of income
In our working years, our income generally comes from one or two sources, salaries and wages or business income. In retirement there are multiple sources of income. Most retirees will have some benefit from Social Security, either their own retirement benefit or spousal benefits. Surviving spouses and divorced spouses (and surviving divorced spouses) can receive benefits as well. A great feature of Social Security is that it provides inflation-adjusted payments for life. There is no need to calculate withdrawal rates from Social Security. This provides a valuable hedge on longevity risk. In addition to Social Security there may be a pension. Pensions are less common these days, but some employers still offer them, and government employees often have them. Then we get to financial assets, such as stocks, bonds, life insurance, and annuities. Income can come from these sources as dividends, price appreciation, interest, cash value, and annuitization. A common belief is that all retirement cash flow comes from dividends or interest but that is not necessarily the case. Declining interest rates and dividend yields, in favor of stock buybacks, have made living off of portfolio income alone challenging.
Selling liquid assets that have appreciated in value is a valid way to generate retirement cash flow. Many companies today prefer stock buybacks over dividends which give shareholders the choice of deferring taxes by holding the stock, which should appreciate as outstanding shares are reduced, or realizing gains by selling the shares. Strategically selling stocks is a way to generate cash flow and allows for flexibility in managing taxes.
In this way, generating cash flow in retirement is like a layer cake with different layers of income from different sources. Each type of income is treated differently for tax purposes, and the account type which is used can have another set of rules. This leads to the last point, which is that retirement income offers greater complexity, but also greater flexibility over taxation.
Greater flexibility and complexity of taxation
For employees, there isn’t much control over taxation. When you receive a salary, you can defer or contribute some of that income into retirement accounts like 401(k)s, Roth IRAs, and Health Savings Accounts, but there are contribution limits to those accounts. Business owners will have more control over which income is considered salary versus what is retained in the business and the timing of deductible business expenses, but business success will generally lead to paying more taxes. In retirement some income can be deferred or pulled forward and different account types can be utilized strategically to manage taxes.
For example, Social Security benefits can be claimed as early as age 62 or delayed until age 70. For most people, 85% of Social Security benefits are taxable. Delaying claiming Social Security benefits defers the taxes due on those benefits in addition to increasing the monthly payments for life. This can provide a window for Roth conversions, as we’ll discuss later.
A common rule of thumb is to take withdrawals from taxable accounts first, then tax-deferred accounts such as Traditional IRAs, then finally Roth IRAs. The math shows that preserving tax-advantaged accounts is beneficial, if possible. Appreciated stocks held for over one year and qualified dividends in a taxable account will receive favorable capital gains treatment, which could lower your tax bill versus interest payments or withdrawals from tax deferred accounts which are taxed as ordinary income. That said, there may be advantages to utilizing tax-deferred accounts early to take advantage of low tax brackets early in retirement, either through withdrawals for lifestyle spending or for Roth conversions. These strategies can require a lot of analysis but can potentially reduce tax rates considerably throughout retirement. Roth IRAs, which allow tax-free withdrawals, are a great asset to leave to heirs or a surviving spouse who will be subject to single-filer tax brackets as opposed to married-filing-jointly brackets, which is why these assets are saved for last.
After age 59 ½, distributions can be taken penalty-free from Traditional IRAs, 401(k)s, and Roth IRAs, and required minimum distributions don’t begin until age 73. Distributions from 401(k)s and Traditional IRAs are treated as ordinary income, distributions from a Roth IRA are tax-free, for example. Qualified Charitable Distributions can begin at age 70 ½ for those that are charitably inclined. Qualified Charitable Distributions allow you to distribute IRA funds directly to a charity without recognizing the income. This is helpful for managing required minimum distributions that are larger than needed for retirees. Lastly, Roth conversions early in retirement can reduce future taxes on Social Security benefits, Medicare Income-Related-Monthly- Adjustment-Amounts (IRMAA) surcharges, required minimum distributions, and to provide a tax-free asset to heirs.
There are many degrees of freedom when planning retirement income, and it pays to be proactive. We can’t predict the future or control market returns, but we can use reasonable estimates for the growth of different assets and develop a plan to manage taxes.
Zeke Anders – Planning Specialist | zanders@twickenhamadvisors.com
Disclaimer
Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.
