The Ultimate Guide To Generating Investment Income In Retirement
Generating investment income to supplement a retirees cash flow needs requires careful planning and an awareness of how different types of accounts are taxed. When done properly you can actually see an improvement in a families probability analysis for a success retirement. I put this article together to share with you some of the things we have learned over the last 40-years of helping families with their finances. Let’s dive right in to learn about some of the best practices for generating investment income in retirement.
Income Sources
In retirement, there are various sources of income that retirees can rely on to fund their expenses. Some of these income sources are guaranteed, while others are less certain.
Guaranteed Income Sources:
Social Security: Many retirees receive Social Security benefits, which can provide a steady source of income throughout retirement.
Pension Plans: Retirees who have pension plans from their employers can benefit from regular pension payments as part of their retirement income. Unfortunately pension plans are a dying breed and have been replaced with 401k/403b plans, shifting retirement income responsibilities from the employer to the employee.
Income Annuities: Annuities are financial products that provide regular payments to the holder, offering a source of guaranteed income in retirement.
Less Certain Income Sources:
Investment Income: Income generated from investments such as dividends, interest, and capital gains can contribute to a retiree's income stream. This is the focus of todays article.
Part-Time Work: Some retirees choose to work part-time during retirement to supplement their income and stay active.
Rental Income: Retirees who own rental properties can earn rental income, which can help cover expenses in retirement.
Diversifying income sources can help retirees ensure a stable and reliable income stream to support their lifestyle in retirement.
As a general rule, we prefer guaranteed income sources to cover at least 50% of a family’s household expenses. If the total guaranteed income falls short of 50% then it makes sense to consider purchasing an income annuity to fill the void. To learn more about income annuities, check out our article, “Maximizing Retirement Income With Income Annuities”.
Withdrawal Rates
Withdrawal rates is one of the most valuable tools available to get a quick sense of a family’s financial strength. It compares a family’s total portfolio value to their withdrawal needs. An example might be helpful.
Example: John & Mary have a total portfolio value of $1m and they need $50K/year to supplement their other income sources to cover their household expenses. If you divide their cash flow need of $50K by their total portfolio value of $1m you arrive at a withdrawal rate of 5%.
As a general rule, the lower the withdrawal rate the better and the more financially stable that family’s finances are. If the withdrawal rate is too high then it usually means the family is putting too much stress and dependency of their portfolio to generate investment income and the greater the risk that the family will run out of money too soon.
The 4% Rule
The 4% rule says take out 4% of your money when you retire, then adjust for inflation each year after. This rule uses past market data to determine a safe withdrawal rate for a 30-year retirement period. It also presumes that the family invests in a diversified portfolio.
The 4% rule is meant for families in their late 50s to early 60s because a 30-year runway it typically a good fit. However, as modern medicine stretches the runway further, the 4% rule may someday become the 3% rule. How many things at the Dollar Store are still $1? Things change and we have to monitor these things.
The 4% rules is not an appropriate benchmark to use for someone who retires at 50 years of age, or for someone who is 80. A 50-year old will likely want and need their assets to last longer and an 80-year old may have sacrifices some of life’s wants and desires because it it unlikely they will make it to 110. So age matters and different withdrawal rates should be used to gauge a family’s financial strength. Here are some withdrawal rate ranges to use depending upon the age of the retiree.
Age 60: 3%-4%
Age 70: 5%-6%
Age 80: 7%-8%
The above withdrawal rates presume that a family is okay if the last check they ever write bounces. In their scenario the portfolio assets aligned perfectly with the families final breath and typically only the house is passed onto the heirs. If instead the family wants to pass on more than just the house to their heirs then using a lower withdrawal rate is preferred.
There are times that we do deviate from the above withdrawal rates. For example, if a retiree wants to delay turning on social security benefits until a later age to earned delayed credits, then it usually make sense to use a higher withdrawal rate to bridge the gap. This strategy usually results in a lower withdrawal rate after social security benefits begin now that these benefits are larger due to the delayed credits. If you want to learn more about earning delayed credits and social security claiming strategies, check out our article, “Optimizing Retirement - Social Security Claiming Strategies”.
Effective Tax Strategies
Tax considerations should be a primary focus when it comes to generating investment income in retirement. Different types of accounts generate different types of tax ramifications. Generally speaking we spend down accounts in the following order:
Excess cash at the bank (beyond emergency reserves)
Non-retirement investment accounts (individual, joint or trust accounts)
Retirement investment accounts (IRA, Rollover-IRA, Simple-IRA, SEP-IRA, 401k, 403b)
Roth (aka Roth-IRA, but I don’t like using IRA because it makes it confusing, especially for someone who doesn’t talk about these types of accounts everyday)
Bank Accounts
Cash is the most tax efficient asset to spend down because taxes have already been withheld from it. You only pay taxes on the interest that is earned on the cash. So you can take money out of your checking or savings accounts with NO tax liability.
It’s important for retirees to have emergency reserves at the bank. Due to “sequence of return risks” it usually makes sense for new retirees to keep more in emergency reserves than they may otherwise need after 5+ years of retirement. We typically recommend 10% of liquid assets (excluding the primary residence). If a family has more than enough in emergency reserves, then it often makes sense to spend down these assets first because they are usually the least productive accounts from a performance point of view.
Non-Retirement Accounts
Once your cash assets are where we want them to be, then we typically turn to non-retirement accounts to supplement cash flow needs. Non-retirement accounts generally pay taxes on interest, dividends and capital gains.
Every non-retirement brokerage account has a cash bucket. It is this cash bucket from which money is transferred from your non-retirement account to your checking account at the bank where you pay your bills.
The cash bucket is usually funded with interest and dividends that are earned from other securities in the account. If the interest and dividends is not enough to cover the draw then we need to sell assets. Fortunately when we sell assets, only the profit is subject to taxes, in particular capital gain taxes. Let's look at an example:
Example: John and Mary have a non-retirement trust account at Charles Schwab. The account currently has $15,000 in the cash bucket. The investments in the account generate interest and dividends of approximately $1,000/mo that is NOT reinvested and is deposited into the cash bucket. Their monthly draw from the account is $5,000/mo. Let’s review the math.
Current month:
Beginning value of cash bucket: $15,000
Draw -$5,000
Interest and dividends +$1,000
Ending value of cash bucket: $11,000
Second month:
Draw -$5000
Interest and dividends +$1,000
Ending value of cash bucket: $7,000
Third month:
Draw -$5,000
Interest and dividends +$1,000
Ending value of cash bucket: $3,000
Replenish cash bucket by selling $15,000 of assets that may trigger capital gains
New ending value of cash bucket: $18,000
Rinse and repeat
Retirement Investment Accounts (i.e. IRA)
If a family’s emergency reserves is where they want it to be, and the non-retirement account has been depleted, then we shift our attention to retirement investment accounts to supplement cash flow needs. The thing to know about retirement account withdrawals is that 100% of what you withdraw from the account is fully taxable at the retiree’s highest marginal tax bracket. So taxes will always be higher when you take a draw from a retirement account.
These types of retirement accounts have a unique feature compared to other types of investment accounts. These retirement accounts have what’s called required minimum distributions (RMDs). These accounts have never paid taxes and the government/IRS wants to collect tax revenue from them at some point and this is the point where that begins.
RMDs are formula driven using both the value of the account and the owners age. The RMD represents the amount of money that needs to be distributed from the account each year. The age at which a retiree needs to start taking these RMDs is now age 73 (2024). The age has changed a couple of times over the last couple of years and was previously 70.5, then age 72, but it now stands at 73. The amount of money that needs to be distributed is approximately 4%-5% of the account value. You can learn more about RMDs by viewing our article called, “Understanding Required Minimum Distributions (RMDs)”.
Even if a family does not need the money to support their cash flow needs they still must take their RMD. Remember, this is about making sure the government/IRS generate tax revenue.
If a family has enough bank and/or non-retirement accounts then we typically suggest only taking the RMD. Retirement account owners are allowed to take out more than their RMD but there is little incentive to do so as it will only result in higher taxes. If the bank assets are already where they need to be at and the non-retirement accounts has already been liquidated, then taking whatever the family needs to fund their cash flow needs from the retirement account may be our only options.
There are times when we may suggest that a family takes withdrawals from their retirement before RMDs begin. For example, if a family’s tax liability is really low then we may review Roth Conversions to take advantage of the lower tax liability and tax rates. A family’s tax liability is typically lower than normal starting after retirement but before RMDs or if the family is experiencing very high deductible medical expenses typically resulting from nursing home expenses.
Roth IRA
From a tax point of view, Roth IRA accounts are about as good as it gets. They not only grow tax deferred (similar to retirement accounts) but they also provide for tax-free withdrawals (after 5-years) and and are not subject to RMDs. The only downside is that you can only make AFTER-tax contributions into a Roth account. We work so hard to get funds into these accounts in a tax efficient manner, so that once they have been funded we hate to spend these assets down in retirement.
There are times when a family has already pushed their tax liabilities higher than normal, or when any further distributions from their retirement account or non-retirement account may push them into a higher tax bracket. In these situations we will consider taking a withdrawal from their Roth to cover the shortfall.
More often than not, we view Roth IRA accounts as a great account to leave to heirs if you don't need the account and can afford to do so.
Which Assets To Sell
Now that we discussed which accounts to go after first to supplement investment income needs, the next question is which asset(s) to sell to fund to support cash flow needs. The answer is usually the same for both non-retirement accounts and retirement accounts, but not always.
Default Strategy
You've probably heard the saying, "buy low and sell high". Easy to understand, but sometimes hard to do. We build this rule into our trading software as the default solution when raising cash to replenish the cash bucket that support the draw that is needed.
What this entails is selecting a target allocation for EACH security within the portfolio. We then look to see which securities are currently valued HIGHER than their target allocation. These are the securities that we trim. This also has the added benefit of rebalancing the account, selling high and reducing risk. Let's look at an example:
Example: John & Mary need to raise $15,000 to replenish their cash bucket. They have twelve different assets within their non-retirement account that each have a target allocation of 8.33%. Two of their assets are invested in bonds and the market has struggled as of late, dragging down the other ten assets in their portfolio.
The two bonds have performed well as there has been a "flight to safety". As a result they both now represent 9.33% of the accounts value. Our trading software is programmed to identify the overweight exposure and to replenish the cash bucket by trimming these to bonds.
The disadvantage to this default strategy is that trades done within a non-retirement account often triggers a capital gain. That is the byproduct of "selling high" disciplines. We will often look to use our tax loss harvesting strategy to reduce or eliminate profits but sometimes there aren’t available losses to use. In these situations we will look to implement our alternative strategy that I will discuss next.
Alternative Strategy
If realizing additional profits is not ideal, then we can elect to sell other securities that maybe have a smaller profit or maybe no profit. This usually results in the account being out of balance for a period of time, which can increase the risk in the portfolio. Sometimes this tradeoff is acceptable, especially if we are close to year end and get a clean slate starting in January where we can rebalance the portfolio to get back in line with our targets.
Ongoing Monitoring
It is imperative to monitor and test withdrawal rates each year. We do this within our financial planning software called eMoney.
eMoney allows us to calculate current withdrawal rates as well as project future withdrawal rates. This makes it much easier to determine if the withdrawal rate is sustainable or not. If not then we can address this with families early on when the necessary adjustments are less severe.
Another tool within our software is the ability to run Monte Carlo simulations. These simulations run through hundreds, if not thousands of scenarios to put together a range of possibilities and to forecast the probabilities of outcomes. In the context of financial planning, Monte Carlo simulations are often used to analyze the probability of different outcomes in investment portfolios based on various input variables and assumptions. The results give us a sense of a families probability of success. If a family wants their assets to last until they reach age 100 and the Monte Carlo score comes back at 80+ then the probabilities are strong that the family will meet their goal.
Conclusion
Drawing down assets in retirement is a critical aspect of managing your finances and ensuring a comfortable and sustainable retirement. By understanding the different strategies for drawing down assets and following some general tips for asset management, you can make the most of your retirement savings and enjoy financial independence in your golden years. Remember to regularly review and adjust your plan as needed to ensure that your assets last throughout your retirement years.
Investment income and withdrawal rates are great subjects to bring up with a financial advisor. If you don’t have one but want to work with one then feel free to reach out to us to schedule a complimentary appointment. You can also find a local advisor by searching “financial advisor near me” to find one who can help. Please remember that nothing referenced in this paper should be construed as tax or legal advice.