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How to efficiently turn savings into income

Consider our two-step, tax-savvy plan to help turn savings into retirement income.

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If you're like many people, you reach retirement with a mix of investments and accounts. After all, there are many tax-advantaged ways to tuck money away for retirement, such as a 401(k) or 403(b), a traditional or Roth IRA, or a deferred annuity.

So how do you transition what you've saved into an income-generating retirement portfolio that has the potential to last as long as you do?

Before you start, you’ll need a budget to estimate your income needs—and wants—in retirement. (Read Viewpoints: “What will you spend in retirement?”) Once you have an estimate, you can then begin to identify income sources to cover both essential (needs) and discretionary (wants) expenses.

Here is a two-step plan to help you do just that:

Step one: Cover essential expenses with lifetime guaranteed income1 sources.

We believe that most investors should strive to cover essential expenses like food, health care, and housing with lifetime, guaranteed income sources. Because Social Security and pensions aren’t always enough, many people may need to purchase an annuity. Income annuities are one of the key ways to generate lifetime income.

How might you fund an annuity? Knowing which assets or accounts to use and in what order can potentially reduce taxes and help you stretch your retirement savings. Consider our funding hierarchy below.


How to fund an annuity: a hierarchy
Order Why
1. Annuitize an existing tax-deferred annuity. The transaction is tax free. Each annuity payment will be partially taxed, and generally at a lower rate.
2. Use money from tax-deferred accounts. The transaction is tax free (provided certain conditions are met). Each annuity payment will be taxed as ordinary income.
3. Use money from taxable accounts. The transaction may be taxable. Only a portion of each annuity payment will be tax free.
4. Use money from a tax-free account. The transaction is tax free. Each annuity payment will be tax free.

Be choosy, too. Some annuities have high embedded fees, so you’ll want to look for a low-cost annuity from a well-established and financially strong company. “Do a quality check,” says Roy Benjamin, vice president and actuary at Fidelity. “Consider the issuing insurance company. Ask yourself: Is the company in strong and stable financial health?”

Read Viewpoints: “A shopper’s guide to annuity fees” and “Create income that can last a lifetime.”

Step two: Cover discretionary expenses with nonguaranteed income sources.

After covering essential expenses with guaranteed income, you‘ll probably still need additional income to cover discretionary expenses—the fun stuff like travel, hobbies, and gifts for the grandkids. For this, you will likely need to tap the remaining portion of your investment portfolio.

Be careful not to withdraw too much too quickly, however. Today’s 65-year-old retirees may need their portfolios to last 25 years or more. History suggests that holding withdrawals to 4%– 5% a year is a good place to start, though you will want to adjust your plan to your personal circumstances. (Read Viewpoints: “Eight tax-smart savings tips.”)

Don’t automatically assume you should invest conservatively just because you’re retired. Most retirees still need to grow their portfolios, which means some allocation to stocks. Plus, if your essential expenses are covered by Social Security, pensions, and annuities that provide lifetime income, you may be able to take on some additional risk with your remaining assets.

Finally, make sure to take taxes into account as you withdraw money from your investment portfolio. In general, it may make sense to start with taxable accounts where capital gains are taxed at significantly lower rates than withdrawals from tax-deferred retirement accounts and annuities. What’s more, using your taxable assets for retirement withdrawals leaves the money in your tax-advantaged accounts in place, where it has the potential to grow tax deferred or tax free. For a suggested tax-efficient withdrawal strategy, see the table below.

Withdrawals from an investment portfolio: a hierarchy
Order Why
1. Taxable: brokerage or bank Long-term capital gains are taxed at relatively low rates and can potentially be offset with capital loses.
2. Tax deferred: traditional IRA, 401(k), 403(b), or governmental 457(b) The taxable portion of withdrawals is taxed as ordinary income. If no after-tax contributions are made, then the withdrawal is 100% taxable as ordinary income.
3. Tax free: Roth IRA or Roth 401(k)2 Earnings and withdrawals are tax free, provided certain conditions are met. The longer you keep assets in these accounts, the longer they have the potential to grow tax free, be tapped for unexpected expenses, or be left to heirs.
4. Tax-deferred annuity For annuities funded from savings (other than an IRA), withdrawals are treated as earnings and taxed at ordinary income tax rates until all earnings have been withdrawn. After all earnings have been withdrawn, withdrawals of principal are tax free. Withdrawals from annuities funded with tax-deferred or tax-free investments are subject to the tax provisions outlined above.

You may also take withdrawals from more than one type of account at the same time to strategically manage the impact on your taxable income and potentially avoid being pushed into a higher marginal income tax bracket (see table right). For instance, you may want to consider withdrawing an amount from tax-deferred retirement accounts, taxed as ordinary income, up to the next tax bracket. Then, if you need more income, consider withdrawing from a taxable or tax-free account, because it isn’t taxed as ordinary income and won’t move you into a higher bracket.

The Wilsons: a hypothetical example

Let’s take a look at a transition strategy for a hypothetical couple, the Wilsons, using the Fidelity Income Strategy Evaluator®3, which we created to help you test different income-generating portfolio options. It doesn’t offer personalized advice, but it can give you a good estimate of your options.

Marsha and Charles Wilson are both age 63 and retired. They have $600,000 in savings invested in a balanced portfolio of 50% stocks, 40% bonds, and 10% short-term investments. Their portfolio goals include growth potential, preservation of assets, protection of income, and flexibility.

The Wilsons have $4,200 in monthly expenses—$3,000 essential and $1,200 discretionary. Social Security and pensions put $2,635 in their pocket after taxes each month (they have a 15% effective income tax rate). So they’ll need $1,565 more a month from their savings, $365 for essential expenses. They would like this income stream to last for 31 years.

Given their goals, the Evaluator suggests an income portfolio with two components: investment income and guaranteed income (fixed income annuity and variable annuity).4 The Wilsons could take about $255,000 from tax-deferred sources, like Charles’s 401(k), to purchase the two suggested annuities to fill their essential spending gap. Then they could fund their discretionary expenses from an investment portfolio, invested 50% in stocks, 40% in bonds, and 10% in short-term investments.

The result, detailed in the table below: $1,565 in monthly income, including enough guaranteed income to cover the Wilsons’ essential expenses. Plus, they would have roughly $90,000 left over, which could be used for emergencies, bequests, or other purposes. (View the details (PDF).)

Learn more

Clearly, there is much to consider when transitioning your life savings into an income-generating portfolio. Here are some ideas to help you get started on your plan.

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund or annuity and its investment options. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
1. Guarantees are subject to the claims-paying ability of the issuing insurance company.
2. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, become disabled, make a qualified first-time home purchase, or die.
3. Fidelity Income Strategy Evaluator is an educational tool.
4. Principal value and investment returns of a variable annuity will fluctuate, and you may have a gain or loss when money is withdrawn.
5. IMPORTANT: The projections or other information generated by Fidelity’s Income Strategy Evaluator (ISE) tool regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Estimates of potential income and assets illustrated by the tool are in future dollars and are based on data entered, product attributes, and Income Strategy Evaluator assumptions, including market performance assumptions based on hypothetical scenarios using historical data. Other investments not considered by Income Strategy Evaluator may have characteristics that are similar or superior to those being analyzed. Numerous factors make the calculations uncertain, such as the use of assumptions about historical returns and inflation, as well as the data you have provided. Our analysis assumes a level of diversity within each asset class consistent with a market index benchmark, which may differ from the diversity of your own portfolio. Results may vary with each use and over time. Fund fees and/or other expenses will generally reduce your actual investment returns and, other than the applicable annual annuity charges for the variable annuity, are not reflected in the hypothetical projections generated by this tool.
The Wilsons’ retirement income plan chart: Essential expenses are matched at an assumed 0% return level, and total expenses (essential and discretionary together) at the 50% confidence level. The average market conditions (50% confidence level) are used to match the total income need.
Investment portfolio assumption: Illustrations of the investment component are based on a balanced target asset mix. The balanced target asset mix is composed of 35% domestic and 15% foreign stocks, 40% bonds, and 10% short-term investments. Several hundred historical financial market return scenarios were run to determine how the asset mixes may have performed. The results are based on an average market (50%) confidence level.
Guarantee period: This is a feature available on certain fixed and variable income annuity contracts. A contract with a guarantee period provides annuity income through a specified date even if no annuitant lives to the end of the guarantee period. If no annuitant lives to the end of the guarantee period, each beneficiary will continue to receive income for the remainder of the guarantee period (note that certain annuities give the beneficiary the option of choosing a commuted value as a lump sum benefit instead). A contract with a guarantee period will provide lower annuity income on each annuity income date than an otherwise identical contract without a guarantee period.
Fixed income annuity assumption: The fixed income annuity is assumed to be a lifetime annuity with a 10-year guarantee period, a 2% cost-of-living adjustment, and a 100% survivor benefit at the death of either annuitant. In order to arrive at the estimate, the best quote available as of September 8, 2014, was used from among the fixed income annuities distributed by Fidelity Insurance Agency, Inc.; these annuities are issued by third-party insurance companies, which are not affiliated with any Fidelity Investments company. Rates may change daily.
Variable annuity assumption: The variable annuity is assumed to be a joint-life variable income annuity with a 10-year guarantee period, a 3.5% benchmark rate of return, a 0.60% annual annuity charge, and a 100% survivor benefit at the death of either annuitant. The illustration assumes an asset allocation consistent with VIP FundsManager 60.
The variable income annuity values reflect the deduction of the annual annuity charge. The 0% rate of return is equivalent to a –0.60% return after this charge is reflected. Fund fees will also apply and are not reflected.
Benchmark rate of return: This is one factor used to determine a variable income annuity’s initial and subsequent payments (note that it is not a guaranteed rate of return). Assuming withdrawals are not taken from the contract date to the first annuity income date, and from one annuity income date to the next, then annuity income will (a) increase if the annualized investment return for the contract is greater than the benchmark rate of return or (b) decrease if the annualized investment return for the contract is less than the benchmark rate of return. The annualized investment return includes the contract’s fund performance minus the annuity and fund fees.
The amount of each payment from a variable income annuity is not guaranteed and may decrease based on the performance of the selected investment option.
The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
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