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Wealth Column: Replacing income in retirement

You want to be sure your retirement savings will help you maintain your lifestyle during a retirement that could last 20 or 30 years or more.

Bruce Helmer and Peg Webb sit next to each other at a table.
Bruce Helmer and Peg Webb, financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on KLKS 100.1 FM on Sunday mornings.
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Let’s assume you’ve done a good job saving through your retirement account at work or on your own through a brokerage or bank account.

Maybe you’ve been thinking — what’s next? What will you need this money to do? Of course, you want to be sure it will help you maintain your lifestyle during a retirement that could last 20 or 30 years or more. You’ll also need enough to handle the tax bill that will come each year. And you may want to ensure that it can provide a legacy for your loved ones after you’re gone.

There are at least four risk factors that you need to consider when generating income that will last over your lifetime:

  1. Longevity — It’s nearly impossible to predict how long you’ll live, and therefore how long your income will need to last. 
  2. Inflation — Rising prices erode the purchasing power of each retirement dollar.
  3. Changing public policy —Tax rates in the future may go up or down, as may government-funded entitlements, both potentially having a significant impact on what you must spend each year.  
  4. Withdrawal rate — It’s tricky to know what rate is sustainable over time.
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Keep in mind that spending does not move in a straight line in retirement. In the early years most people’s spending goes up, as they check off their bucket-list items and make big-ticket purchases. Then, in the middle years, spending tends to level off and even decline. Later in life, health care needs rise, and spending goes up. Planning for this likely pattern will help ensure that your income keeps pace with your changing needs.

Visualizing retirement

We often advise clients not to be too general about what they will do once they retire (travel more, volunteer) but to begin with a concrete vision for what retirement could look like (travel the western coast of Ireland, help out neighbors at the local Senior Center). Being specific will help give you a more accurate estimate of how much retirement income you’ll need to spend each year. It will also help you create a realistic budget and identify ways to cut expenses in leaner years (such as forgoing that expensive cruise). And visualization is an essential component to planning how much money you want to leave to your heirs.

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Then, you need to consider the following nuts and bolts of retirement income planning:

  • Finding ways to generate predictable income streams,
  • Making sure your income is tax-efficient,
  • Figuring out when to claim Social Security benefit,
  • Planning for and managing required minimum distributions from qualified retirement accounts,
  • Ensuring that a good portion of your money is positioned for long-term growth.

We have found many people enjoy tackling each of these activities themselves. Others prefer to work with a financial adviser who is experienced devising retirement income plans under a variety of scenarios. One approach that we have used successfully with clients for many decades, the Your Money Matrix, can help you identify sources, timing and uses for spending down your nest egg.
The bucket approach using Your Money MatrixThe Your Money Matrix approach begins by determining how much cash flow you will need to generate each year from your retirement assets. It should reflect your goals and dreams for how you want to spend your golden years. We have found it’s essential that spouses and life partners need to agree on this vision!

Your Money Matrix is designed to give you confidence that your savings are structured to meet your goals. For example, let’s assume you have investable assets of $1 million for a hypothetical illustration. Here’s how you might set up a three-bucket portfolio using the Your Money Matrix approach.

Short-term bucket — Current Income (one to three years of cash flow) = $200,000

In the short-term bucket, you decide you will need to put in $50,000 to cover your living expenses for three years, for a total of $150,000. You also wisely set aside an emergency fund of $50,000 to cover large, unexpected expenditures such as a new furnace or roof, or for a medical procedure that’s not covered by insurance.

The short-term bucket should hold mostly risk-hedging assets, such as cash and Treasuries. The purpose of this bucket is not to grow — it’s to give you greater certainty that your cash needs will be met over the next few years. A secondary benefit is reducing the impact of short-term market volatility on your portfolio.

Medium-term bucket — Buffer (four to nine years of cash flow) = $300,000

For the medium-term bucket, we estimate needing six years of annual cash flow ($50,000 x 6) totaling $300,000. (To keep the illustration simple, we are not factoring in annual adjustments for inflation, but that would be wise given recent economic trends.)

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This money also earmarks intermediate financial needs such as contributing to your kids’ education, paying down a mortgage or starting a part-time business. The medium-term bucket holds income-generating investments, including low-risk, low-volatility stocks for stable capital gains. Doing this may help you avoid a common problem of having to sell growth-oriented assets on short notice. The medium-term bucket also can serve as a buffer between the short-term bucket and the long-term bucket, and can be used to “top off” the short-term bucket as needed.

Long-term bucket — Growth (10 plus years of growth, little income) = $500,000

The remainder of your portfolio can be allocated to a long-term, growth-oriented bucket that is aligned to your values and long-range financial needs — whether it’s to cover significant long-term health care costs, to leave a legacy for your children or other heirs, or for philanthropic purposes. The long-term bucket generally should have growth assets, such as stocks. Although stocks can be more volatile in the short term, they historically have been able to sustain an investor’s portfolio in the later years of retirement. Assets in the long-term bucket can be also used to replenish the short- and medium-term buckets as needed.

Tax diversification is important

Remember that your household balance sheet or net worth statement doesn’t typically reflect a critical factor in retirement income — tax liabilities. Most people accumulate the bulk of their retirement assets in their tax-deferred IRA or 401(k). However, this creates a significant tax liability in retirement, as withdrawals from these accounts are taxed as ordinary income.

As you consider the time horizon for the cash you’ll need in retirement, also think about how your various accounts are taxed.

  • Taxable accounts: Brokerage and other liquid accounts with realized gains are taxed at year-end.
  • Tax-deferred investment accounts: You pay no tax on your IRA or 401(k) today, but distributions are taxed as ordinary income. Plus, withdrawals made prior to age 59½ are generally subject to a 10% federal penalty.  
  • Tax-advantaged investment accounts: No tax deduction is available to contributions to a Roth IRA or Roth 401(k) account, but earnings accumulate tax-free, and withdrawals can be tax-free.

The basic idea behind tax diversification is: Don’t pay tax on income you don’t need!
When doing distribution planning, Wealth Enhancement Group believes in drawing from each of these buckets over a multi-year strategy, depending on cash flow needs, prevailing and future tax rates, and the timing for when you may need the money.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on News Radio 830 WCCO on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com. Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment adviser. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL.

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