Key Takeaways
One of the hardest things for many near-retirees is figuring out their cash flow needs in retirement. Many have no idea what the typical monthly spending is.
Don’t be surprised if your retirement income keeps you in the same tax bracket (if not higher) than when you were working. There are ways to plan for this.
Make sure you know which income sources are best to start drawing from in early retirement.
Now is the time of year that we’re asking clients and prospects about their plans for the year ahead. Since 1960 was the peak birth year during the Baby Boom, that means a record 10,000 Americans will be turning 65 every single day in 2025. If you or someone close to you will be transitioning away from a paycheck to a retirement portfolio for income, here are some important questions that come up:
1. Are you satisfying your required distributions from IRAs and retirement accounts? Does this cover your expenses; or vice versa?
One of the hardest things for many near retirees is figuring out their cash flow needs in retirement. Most people, even our financially savvy clients, greatly underestimate their average monthly expenses. After reviewing a client’s tax returns and bank statements, etc. we may tell them they’re spending, $10,000 or $20,000 per month. Inevitably, they respond: “No way. It can’t possibly be that much!” And then we show them not only their recurring monthly bills, but all the gifts and travel, and one-off home and auto repairs, and out-of-pocket medical expenses, etc. That’s when they tell us: “Oh my god; you’re right!” Those one-off expenses always come up. You must be conservative and build them into your budget with plenty of buffer.
2. Do you know the right age to start taking Social Security?
When new clients come to see us, some have already started taking Social Security. We can’t reverse that decision, but for everyone else, we look at the optimal age to start taking Social Security, whether it's at early retirement age, full retirement age or waiting until the maximum deferral (age 70). There’s no one-size-fits-all answer. A great deal depends on your portfolio size and what your cash flow situation looks like. You get an 8% raise every year you delay taking Social Security between at 67 and 70, so it pays to wait as long as possible if your other sources of income can support your lifestyle. Also remember that Social Security gets taxed as ordinary income, so that must also be factored into your retirement cash flow assumptions since taking Social Security before it’s mandatory could push you into a higher tax bracket.
3. Are you taking advantage of after-tax funds and analyzing which type of account may make more sense to you?
Here the focus is on having a distribution strategy that's done in the most tax efficient way possible. Many clients in this age bracket have more money in brokerage accounts or after-tax assets than they do in IRA money. From a planning standpoint their required distribution might be small and cover some of your expenses. But then we must start taking distributions from after-tax assets, which could be more tax beneficial. If you retired before 73, maybe we just don't touch the IRA at all. That way we can have several low tax years, because we're taking from the brokerage account. That gives us more control from a capital gains perspective. Often it makes sense to let the IRA continue to grow, but we can also start looking at other tax strategies, such as Roth conversions, when you must start taking money from your IRA at age 72 (or 73 if you reached age 72 after Dec. 31, 2022).
One of the biggest misconceptions for recently retired people is that they must start taking money from their retirement assets immediately because they’re officially “retired.” Not true. There are often better strategies that will benefit you in the long run. That’s where an advisor can be a big help.
Real World Example
Let’s say a couple comes to us when they’re retiring at age 67. Because of their age, they’ve been managing their investment conservatively with a significant portion of the portfolio in cash or savings accounts. After doing a full analysis, we might say: “Okay, we'll let your IRA continue to grow. You have lots of money invested conservatively and it won't trigger a lot of capital gains. Let's keep that IRA in reserve to cover your expenses for the next year. With a full year's worth of paycheck replacement already covered, we can put it in a money market where it will earn something better than your savings account. Now we can essentially replace your income for a full year with no tax impact. This allows us to look at other strategies such as gain harvesting, if you have old stock positions with large unrealized capital gains, or potentially a Roth conversion, among other strategies.
4. If retiring, are you factoring in the changes to your tax situation?
Many early retirees are surprised to learn they’re in the same tax bracket (if not higher) than when they were working. That’s because the required minimum distributions from retirement accounts and pensions can add up really fast, not to mention Social Security benefits. Fortunately, there are many ways we can mitigate their tax hit through careful retirement planning and estate planning. Taking this holistic approach to your financial situation is another good reason to work with an advisor.
5. Are you withholding the proper amount from IRA/retirement account distributions? Many people assume they just need to draw enough out of their retirement accounts to meet their monthly cash flow needs. They overlook the need to withhold a portion of their retirement distributions to pay taxes. Like Social Security, income from retirement accounts is also taxed as ordinary income. If you don’t withhold as you go, you could be facing a whopping tax bill in April. Keeping funds in a retirement account vs. rolling over into an IRA can have a huge impact on your retirement cash flow calculus, as retirement plans generally have a mandatory 20% tax withholding requirement from all distributions, which may not be an appropriate amount for your situation. Don’t be a do-it-yourselfer here.
6. Are you factoring in any possible rebalancing or common year-end tax strategies when looking ahead? I’m advising a 60-something couple who's still working full-time. Their money is evenly split between after-tax assets and retirement accounts. Their decision to stay fully invested has paid off for them because the domestic stock market has performed very well over the past two years. But now their portfolio is way too aggressive considering how close to retirement they are. It needs to be rebalanced. The husband’s income is a little lower this year because he was out of work for a few months while changing jobs. I told the couple: “This is a perfect time to rebalance your account. Let's get take some of your gains off the table since you’ll be in a lower tax bracket for calendar year 2024 than you will in 2025 and beyond.
Conclusion
Cash flow and retirement planning are complicated. We have powerful software and years of experience at our disposal to guide you. No matter who you decide to work with at this critical time in your life, don’t try to do it yourself. If you or someone close to you has concerns about your retirement readiness and cash flow situation, don’t hesitate to reach out. I’m happy to assist. Cash Flow Planning 2025
BRENDEN LEESE, CFP® is an Associate Wealth Advisor at Novi Wealth Partners
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