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. 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 of generating 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 and work with a tax adviser before taking any of the following steps.
Annuitize an existing tax-deferred annuity.
If you've saved for retirement in a tax-deferred annuity, now may be the time to annuitize it, turning it into a steady stream of guaranteed1 income payments. You aren’t taxed when you do this. Instead, each annuity payment will be taxed appropriately.
Tap tax-deferred accounts—401(k)s, 403(b)s, or traditional IRAs.
If you don’t own an annuity, you may want to consider rolling over the money from a traditional IRA, 401(k), or 403(b) to purchase one. You aren’t taxed on the amount you roll over (provided certain conditions are met). Instead, each annuity payment will be considered taxable income and will be subject to ordinary income tax, assuming all contributions had been made pretax.
Use taxable accounts—brokerage or bank.
After utilizing tax-deferred balances, you may want to consider turning to taxable bank or brokerage accounts. If you need to sell an investment from a taxable account, consider these suggestions, which have the potential to help minimize the tax impact:
- Consider selling investments that have lost value, and which can generally be used to offset capital gains and up to $3,000 a year in ordinary income. First, realize short-term capital losses to offset short-term capital gains, which are taxed at ordinary income tax rates. Then, realize long-term capital losses to offset long-term gains, which are taxed at lower capital gains rates.
- Use available cash.
- Realize long-term capital gains, which are taxed at lower capital gains rates.
- Realize short-term gains, which are taxed at higher ordinary income tax rates.
Turn to tax-free accounts—Roth 401(k) and Roth IRA.
Typically, Roth accounts would be the least favorable of the four for funding an annuity, because the funds in a Roth account can be used, tax‐free, for other purposes and can continue to grow on a tax‐free basis if you don’t use them. But if you have exhausted the other three options and you still want to set up an annuity, you could use savings in a Roth account to purchase an annuity. Thereafter, each annuity payment will be tax free.
Be choosy, too. “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?
Step two: Cover discretionary expenses with non-guaranteed 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: “How can I make my savings last?”)
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.
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 below). 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 $400,000 in IRA accounts and $200,000 in brokerage accounts 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 32 years.
Given their growth, guarantees, and preservation 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 $254,000 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 $92,000 left over, which could be used for emergencies, bequests, or other purposes. (View the details (PDF).)
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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