Retirement Answers

Jacob: 00:01

What we have to do is piece all of these different income streams together to create our new paycheck, and before we can actually know where to pull money from first in retirement, what we have to do is know where your fixed income will be coming from and when those different sources of income will be starting. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place. Hey there. My name is Jacob Duke, and each week, I'll be walking through different tips and strategies to help you succeed in retirement.

Jacob: 00:38

So let's go ahead and get started with today's show. So you're thinking about retirement and trying to figure out how to create a secure retirement income when you decide to stop working. Right now, you are earning a paycheck every two weeks or perhaps every month, and that paycheck covers all of your expenses, but when you retire, that check goes away and it can be pretty overwhelming to know where you should pull income from first in retirement. But even more than that, pulling money from the wrong place at the wrong time could potentially lead to paying more taxes than you need to in retirement. Hey there, my name is Jacob Duke.

Jacob: 01:14

I'm a certified financial planner and the founder of River Tree Wealth, a financial planning firm built to help you retire with confidence. So when you get to retirement, you've got to start piecing together where your income is going come from. And it's hard because you are now responsible for creating your own paycheck in retirement compared to before you were used to just going to work, doing what you needed to do every day, do your job, do it well, and then you would get your paycheck every couple of weeks or every month. But now, you might not have just one paycheck, you might actually have a series of different paychecks. If you think about it, if you've got a portfolio that you've saved and built for your retirement savings, maybe through a four zero one ks or an IRA or Roth accounts, you will have to distribute money out of that account via portfolio distribution.

Jacob: 01:54

So maybe you have some interest or dividends, or perhaps you have to sell some principal to create income for yourself. That's one potential paycheck you could create for yourself. But another one is going to be a social security. So if you paid into the social security system over time, you will receive a benefit at some point, whether it's 62 or later, you will start taking that money in as well. Maybe you have a pension, maybe you have annuity income, perhaps even rental income.

Jacob: 02:18

All these different sources of income in retirement could be there for you depending on your situation. So what you've got to do, instead of getting one paycheck, now you have multiple paychecks that are going be coming to you from all these different places, and often they're going to start at different times. So if you start taking money from your portfolio at 60 and you don't start your Social Security benefits until 65, well, you've got a five year difference between when your portfolio will start giving you money and when Social Security will start giving you money. So, what we have to do is piece all of these different income streams together to create our new paycheck, And before we can actually know where to pull money from first in retirement, what we have to do is we have to know where your fixed income will be coming from and when those different sources of income will be starting. So, we have to understand your sources of income.

Jacob: 03:05

What fixed income sources will you have? Many people are going to have social security, some people are going have pensions, others might have rental income, others might have some annuity income, or you could have all those different sources of income. Each person's situation is going to be different, but the key is you have to understand what your income will be and where it's going be coming from and when it will start. And you have to think of this as the foundation or the base of your overall retirement income plan. So where you pull from in terms of your distributions out of your portfolio in retirement, we can't figure that out until we know what other fixed income sources we have first.

Jacob: 03:38

Now all these different fixed income sources, depending on which ones you have, they're likely not going to replace your former paycheck that you were getting while you were employed at least 100%, but it will cover a portion of your retirement income expenses. So maybe it's 30% of your income need, 50% or even 75% of your income need. It's a good start. So this is the first step. You've to know where your fixed income is going to come from in retirement, and then we can start to evaluate what that shortfall is between your fixed income and your expenses.

Jacob: 04:06

So that's the second step. You've got to understand the shortfall between your fixed income sources and how much you're going be spending in retirement. Now, second part of that is you have to know how much you're going to be spending in retirement, which is often hard to figure out. So what I like to do is recommend a couple different things. You've got to find two numbers.

Jacob: 04:22

The first number is, is how much is your base spending, or how much do you need to spend every single month, such as a mortgage or a car payment or gas or food? How much is the minimal amount of money you have to spend every single month to meet your basic needs? Now, the second number is how much you would like to spend. So we're going to add discretionary spending on top of this. Perhaps you like to go out to eat, perhaps we like to go on vacation, whatever it might be.

Jacob: 04:44

So for example, you could have a base spending need of around $3,000 a month and then a total desired spending need of around $8,000 a month. So that is $5,000 of discretionary spending. So that could be your range, but regardless, I like to have these two different numbers. And what this does is it allows you to have a little bit of freedom or wiggle room to spend more, some particular months or actually spend less in other months if the market's gone down decent amount or, things get tight for whatever reason. You have the ability to adapt and change how much you're spending on a monthly basis to different market conditions or whatever might be going on in your life at that particular time.

Jacob: 05:20

So once we have those two numbers, we can start to identify this gap or the shortfall between our fixed income sources that we've already been talking about, then how much money we will need to be spending. So this is the gap that we've got to fill, and this brings up the third step, which is understanding the different types of accounts that you have. So in general, there are three or so different primary account types. You've traditional, which is tax deferred, you've got Roth, which is after tax or tax free, and then you have brokerage, which is after tax but not necessarily tax free, because you'll have to pay some different capital gains taxes on dividends, interest, or long term or short term capital gains in that brokerage account every single year. So you've got three primary account types that are all taxed differently.

Jacob: 06:01

But a common misconception here is that one of them performs better than another. And that's just not true, they don't perform better than another. All those account types do, is they tell us how each of those dollars in those account types is going to be taxed. So really the only material difference here is that the taxation of each account type is different. You got tax deferred, tax free, and then taxable.

Jacob: 06:20

Now a common thought around which accounts to take from first in retirement is to spend the taxable or brokerage accounts first, so that you can continue to reap the benefits of that tax deferred and tax free growth for longer. And so, you would do is spend on your taxable brokerage accounts or your cash accounts first, would go tax deferred second, and then perhaps probably leave that Roth untouched as long as possible so you can continue to have as much tax free growth in that account as possible. What this would do is it would lower your tax bill right now, but it doesn't take into account the future taxes you might have to pay on your tax deferred accounts throughout the rest of your retirement. Which remember, that's really the main point here. We're trying to figure out how to lower your overall tax bill throughout the rest of your life, not just one particular year.

Jacob: 07:03

And so while this strategy of taking money from the taxable or cash accounts first and spending that all the way down might reduce your taxes in the first few years of retirement. What you've done is now you might be creating a larger tax bill for yourself in the future. So you should have a specific and kind of intentional tax strategy for your retirement income. That strategy should be based on the tax consequences of that decision. Let's take a look at an example to see what this looks like.

Jacob: 07:29

Let's assume you've got Social Security and a small pension and two different fixed income sources that cover a percentage of your needs, but let's say that you need another $40,000 from your portfolio to meet your expense needs in retirement. Now let's say that taxable amount of your social security is $75,000 So you're going to have more than that coming in, because only a portion of your social security is taxable. We're going to talk about that in just a second. But let's say that out of your social security and your pension combined, you're married filing jointly, you have $75,000 of that amount is actually going to fall onto your tax return and be taxable to you. Now, this is important because if you look at the federal tax brackets for twenty twenty four, you're going see that any income above 94,000 is going to jump into the 22% tax bracket from the 12% bracket.

Jacob: 08:18

So that's a pretty significant jump. Now just for our demonstration here, let's just assume that that bracket is not 94,000, let's assume it's 95,000 to kind of keep the numbers round and simple for everyone to understand. So, if we need another $40,000 from our investments or portfolio on top of that $75,000 we're already taking, we could take an additional $40,000 from our traditional IRA, but that means that a portion of that $40,000 will be taxed at 22%, while the other half would only be taxed at 12%. So, $20,000 would be at 12%, going all the way to 95, and the other $20,000 would be at 22%. So, that's a 10% jump on the additional $20 we're taking there.

Jacob: 08:54

So, what can we do? How can we avoid paying that 22% tax rate, which is that big jump on any of these dollars that we would be distributing out for our expenses in retirement? Well, if you have multiple account types, such as a tax deferred like that traditional IRA or your Roth IRA or brokerage account, Well, one thing that you could do is you could split that $40,000 distribution across the different account types, being the taxable, tax deferred, the Roth accounts, and you could let's say take $20,000 from a traditional IRA to fill up the 12% bracket, and you can take the other $20,000 from cash or Roth accounts. So that would be tax free to you that additional $20,000 it would not go on top of the other 95 that you've already filled up in your tax bracket. So instead of paying a total of $6,800 in taxes on that $40,000 you can actually pay $2,400 in taxes.

Jacob: 09:44

And that's a difference of an effective tax rate on that 40,000 of 6% versus 17%. So an 11% difference on the overall $40,000 distribution is really what's at stake here. So just from this basic example, you can see that being intentional or thoughtful about your distribution strategies from your portfolio can make a big difference in your overall taxes paid throughout retirement. So being intentional about where you're pulling income from in retirement and when you're pulling it from those different account types is going to be important to you keeping your overall taxes low and keeping those taxes lower for longer. Now, consideration here is actually how much money you have in a tax deferred IRA or tax deferred four zero one ks, because the approach that I just presented to you might not be the best thing for you if you have a substantial sum of money in a tax deferred account.

Jacob: 10:33

Having that larger tax deferred account balance might actually change your approach because in theory, you can try to keep your tax bill really low in the first few years of retirement, but what you're going to do is build up a larger tax bill for yourself in the back half of retirement because of this thing called Required Minimum Distributions. Now, this is RMDs for short, and what you're probably gonna be doing here is if you have already a large tax deferred account balance and you don't start taking money from that account or have a strategy to lower that overall tax bill, which you could do is build up a larger tax bill for yourself in the future. And those larger future taxes could very well outweigh the tax savings that you could have today from not paying those or taking money out of your Roths right now. So it could be more beneficial for you to actually pay tax now compared to later. And what you've got to do here is you've to evaluate this for yourself.

Jacob: 11:20

So you could be using maybe a spin down strategy or perhaps even a Roth conversion strategy, but either way you've got to evaluate. If I have a decent sum of money, $1,000,000 or more, or perhaps even under $1,000,000 depending on your situation, should I be doing Roth conversions? Should I be doing a spin down of my traditional or tax deferred accounts first, rather than keeping my income taxes really low right now? So, it's really this trade off, do I keep my taxes low right now in retirement in the first few years and delay that into the future, or do I find a way to mitigate the long term tax risk by paying some of those taxes now? Now, another consideration to think about whenever you're deciding where to pull funds from in retirement is going to be your social security income and how that income is going to be taxed.

Jacob: 12:00

Anywhere from zero to 85% of your social security benefits could be taxable to you, but that does not mean that all 85% will be taxable nor that your tax rate is 85%. What this really means is that zero to 85% of your social security could be included in your taxable income. Now, because of how social security is taxed, it's possible that you might pay zero taxes on your social security benefits. Now, you have to do to do that is you have to keep your other income sources really low because of how social security calculations on taxes work. So, if you have social security as your only source of income plus let's say some cash in a cash account and then also Roth IRA income, you gonna pay no taxes on that social security, no taxes on the Roth, and obviously no taxes on the cash that you'd be pulling out of your bank account.

Jacob: 12:45

Now, because the maximum amount of your social security benefits that could be taxable is 85 percent of those benefits, that means that your social security is not taxed the same as normal income. You have to find what's called your combined or your provisional income to determine how much of your social security is taxable. Now, I'm not gonna be getting into that today, but just know that if social security is your only source of income, you're probably not going to pay any taxes on that social security income, but as you begin adding other income sources to that, such as IRA distributions or perhaps a pension or rental income, anything else, parts of your Social Security will become taxable up to that maximum amount of 85% of your benefits. So it's important to consider the regular tax implications of where you're going to be pulling from in retirement, but also the next level of this is to consider how this impacts the taxability of your social security benefits, both right now, but also throughout retirement. Another consideration to think about when it comes to pulling funds from your portfolio in retirement is something called IRMA.

Jacob: 13:44

Now, IRMAA is surcharges that go on top of your normal Medicare Part B and Part D premiums. So, in 2024, if you had a modified adjusted gross income of $206,000 if you're married filing jointly, in 2022, you will have a surcharge on your Part B and Part D premiums. Now it's important to understand that these income thresholds are adjusting for inflation every year, yes, but they are also cliffs. Meaning, if you go over that bracket by $1 you're going to have to pay that surcharge even if you only went over by $1 over the $206,000 if you're married filing jointly. That's why it's really important to know where you stand in terms of your overall income each year compared to these brackets and that way you can plan accordingly.

Jacob: 14:27

Now you might not be above the IRMA income brackets today, but you very well could be in the future once your RMDs kick in, perhaps you have a pension at that point, but also social security or any other sources of income. So what you have to do is you've got to evaluate this and factor it into your decisions around where you pull income from first in retirement. And finally, you've got to consider any other tax planning strategies you might be putting into play whenever you're pulling funds from your accounts in retirement. Now, some of these other strategies could include Roth conversions or tax gain harvesting and pulling money from the wrong account at the wrong time while doing some of these strategies could void the benefits of doing them in the first place at all. So what you can see is where you pull your money from in retirement impacts a multitude of other things such as your taxes on Social Security, taxes on your RMDs, even your Medicare premiums.

Jacob: 15:15

You've got to have an intentional strategy for where you pull income from and when you're pulling it from those different places. And if you're overwhelmed trying to figure out all of these different things or trying to plan out a secure income plan for your retirement, feel free to reach out. I offer a free initial consultation to see if I can help you retire with confidence. There's going to be a link down in the description below where you can book your free call. Thanks for tuning into this week's episode of Retirement Answers.

Jacob: 15:38

I look forward to being right back here with you next week. Hey, it's Jacob again, and I wanted to extend a quick offer to you. If you have a question and you would like to have it answered here on the show, please email me at jacobretirementanswers dot net. And I'd love to answer that question for you right here on the show. Also, wanted to remind you that nothing discussed in today's episode is meant to be financial, legal or tax advice.

Jacob: 16:04

Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.