How should you manage your money in retirement?
People who are retired are often referred to as having a “fixed income,” or living on a set amount of money each year from Social Security, retirement accounts or pensions.
However, in practice, your income could be anything but fixed from year to year—at least in the eyes of the government.
See, one of the determining factors of your tax bill every year is your taxable income. And, as Ellen Derrick, a certified financial planner™ with LearnVest Planning Services, puts it, withdrawing more money from a tax-deferred account for expenses one year is equivalent to having a greater taxable income for that year. And that, of course, means a higher tax bill.
Since you want your retirement savings to last as long as possible, you should pay what you owe in taxes, but not more than you have to. For that reason, you'll want to be strategic when it comes to withdrawing from your retirement accounts and even when it comes to buying or selling things (like property) that can change your tax bill.
As you probably know, different retirement accounts have different tax treatments. When you contribute to a traditional 401(k) or IRA, the money is usually put into the account pre-tax. Though you've skipped paying Uncle Sam at the time of contribution, you will have to pay taxes on that money when you withdraw it. On the other hand, money that's in a Roth IRA or Roth 401(k) has already been taxed, so when you withdraw that money, you won't pay taxes on it. So when you're retired, strategically drawing from different types of accounts can help minimize your taxes.
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We'll explain why retirement income fluctuates and how to make sure you maximize your retirement savings.
How and Why Retirement Income Fluctuates
Although it’s important to figure out how much money you’re going to need for a comfortable retirement and plan your contributions so you can meet that number, it’s impossible to foresee exactly how much you’ll require to live on each year.
Here are a few factors that can affect your retirement income:
Variation in Living Expenses
Just like during your working years, during retirement, you'll have large expenses some years and not others. Buying a new car, going on a fancy vacation or remodeling your kitchen, for instance, are not purchases that you make on an annual basis. Of course, when you're working, your purchases in any given year would never determine your income. (If it did, then life would be a lot easier!) But in retirement, your expenses actually can determine your income because, in order to pay for these things, you will be pulling money from your retirement accounts and paying income tax on that money (unless it’s a Roth account).
"Selling a home or a second home can also change your income, and many people sell property in order to downsize during retirement," Rachel Sanborn, a LearnVest Planning Services certified financial planner™, says.
When you’re selling a property that you’ve owned for many years, the value typically will have increased since the time of purchase. For example, if you purchased a home for $100,000 30 years ago, and it’s now worth $750,000, you will be able to claim an exemption on your taxes for $500,000 of that gain if you are married filing jointly. (If you file singly, you can exclude $250,000 of the gain.) But you’ll still have to pay taxes—typically 15%—on the remaining $150,000 as capital gains.
As you get older and are more likely to need health care, medical expenses can also have an impact on your annual taxable income. Since you can take a deduction for medical expenses over a certain amount on your taxes, your taxable income may be lower in a year in which you spent a significant amount of money on health care. The same goes for other deductions that reduce your taxable income, like charitable contributions. Sanborn recommends working with a financial planner in this situation.
If you own stock in a company or companies, the variability of dividends can also contribute to fluctuations in your retirement income, Sanborn says. Dividends are payments—a portion of the company’s profit—made by a company to its shareholders. Depending on how profitable a year a company has had, as well as the state of the economy, dividends and interest can go up and down, which can, in turn, change the amount of money you accumulate during the year, and that in turn can affect how much you pay in taxes.
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What You Should Do
Sanborn says that you should look at withdrawing funds from your accounts in retirement as “paying yourself your own salary.” In order to make the most of your retirement savings, you should withdraw strategically from your retirement accounts depending on how much income you’re going to make that year. Since these kinds of maneuvers are a lot easier said than done, it's best to consult a certified financial planner on what to do in your particular case.
However, the general withdrawal strategy requires having both post-tax and pre-tax retirement accounts, like a Roth IRA or Roth 401(k) (post-tax) and a 401(k) or IRA (pre-tax). For example, say you are planning to sell your house this year. Since the extra income from the sale will likely have you paying income tax at a higher rate (if the value of the house has increased since you purchased it), you may want to pull money from a Roth-style account that year. This is because contributions to Roth 401(k)s and Roth IRAs are post-tax, meaning that you won't pay taxes on the withdrawal, and that will help keep your taxable income in a lower bracket.
The reverse is also true. When you anticipate a lower-income year, you should withdraw money from your traditional 401(k) or IRA, since these funds are pre-tax. Then, you’ll pay tax on that money at a lower rate due to your lower income and can save your Roth money for a year in which you run the risk of getting taxed a higher rate.
Often, people plan to withdraw a set amount or percentage from their retirement accounts each year, but the trick is to make annual adjustments to your spending and withdrawals. Review your spending at the end of each year and consider lowering your withdrawals the next year. "That way, you eliminate the risk of waking up when you're 75 and realizing that you are going to outlive your retirement savings," Derrick says.