| ||||||||||||
Wish you could generate more income in retirement? Listen up: It may be possible to give yourself a post-retirement raise, perhaps a substantial one, by simply making better financial decisions.
Indeed, research suggests you could potentially boost your spending money during retirement by 30 percent or more by optimizing for seven key variables.
- Social Security timing strategy.
- Withdrawal rate.
- Tax efficiency.
- Asset location.
- Guaranteed income stream (think annuities).
- Cash stash.
- Asset allocation.
“It's definitely possible to significantly increase your after-tax retirement income,” said John Pearson, a financial professional with Barnum Financial Group in Shelton, Connecticut.
That’s welcome news to retirees who under saved, failed to account for longer life expectancies, or underestimated the effects of inflation.
It also underscores the important message that retirees are not mere passengers in their quest for financial security, dependent on the vagaries of stock market performance. Rather, they can and should be active participants, pulling levers to manage risk and improve their own outcome.
“Investing for retirement involves a number of complicated factors,” said Daniel Drabinski, founder of Integrated Strategies in Dallas, Texas.
“Some of these factors include the correct timing to claim Social Security; the choice of an appropriate distribution strategy; tax efficiency within your withdrawal strategies; portfolio construction with a holistic approach; the use of annuities, and permanent insurance to create volatility buffers; and risk optimization.”
Timing your Social Security benefits
Your Social Security timing strategy is arguably the easiest and most effective way to create more retirement income.
If you are eligible, you can begin claiming Social Security benefits as early as age 62. But there are penalties for taking benefits before your full retirement age in the form of a permanent reduction in your monthly benefit check to reflect the additional years you may be collecting — up to a 30 percent reduction if you begin taking Social Security at age 62.
You can maximize your Social Security benefit by waiting until your full retirement age, when you can collect the full amount to which you are entitled.
Better yet, if you can afford to wait, consider delaying benefits beyond your full retirement age, which may enable you to increase the amount of your monthly benefit by up to 8 percent per year until age 70, when delayed credits cease to accumulate.
Thus, a monthly benefit of $1,000 at full retirement age of 67 could be reduced to $700 if taken at age 62, but it would increase to $1,240 if delayed until age 70.
Delaying Social Security benefits, however, may not make sense for you depending on your financial needs, your health status, and your family history. (Learn more: When should I apply for Social Security retirement benefits?)
Withdrawal rate
It may be possible to spend more of your savings during retirement without outliving your assets if you deploy a dynamic withdrawal strategy, versus a static one.
A dynamic strategy adjusts the amount of your retirement income annually based on market performance, while a static strategy involves spending a flat percentage of assets every year. In down years, you would spend only enough to cover your living expenses, and in higher-performing years you would set a ceiling on how much more you can safely spend above your target withdrawal rate.
In 2024, Vanguard reviewed the portfolio journeys of three hypothetical individuals with three different retirement start years: 1973, 1983, and 1993, meant to reflect a range of economic and market conditions. The retirees all started with a $1 million portfolio that was adjusted for inflation and allocated 60 percent to U.S. stocks and 40 percent to U.S. bonds.1
Relative to a flat 4 percent annual withdrawal rate, which produced annual retirement income of $40,000 per year, the dynamic spending strategy allowed all three retirees to receive more income over the course of their 30-year retirement without depleting their portfolios.
The individual who retired in:
- 1973 enjoyed nearly $26,000 more throughout their retirement.
- 1983 enjoyed $1.5 million more throughout their retirement.
- 1993 enjoyed $731,000 more throughout their retirement.
Past performance, of course, is no guarantee of future returns.
Guidance from a financial professional can be instrumental in helping you reach your goals.
“Ideally, utilization of tools like these should be part of an overall strategy and not just a one-off,” said Pearson. “I always like to use the metaphor of a Rubik's Cube. Sure, it may be easy to solve one side of that cube, but what impact does it have on the rest of your plan? Most retirees would probably need at least some help from a qualified advisor.”
Tax efficiency
You may also be able to keep (and spend) more of your hard-earned savings by minimizing your taxable income.
“The decumulation phase can be more complex than when you’re accumulating assets during your working years, as you must begin to convert assets into income streams and address the many risks associated with retirement,” said Drabinski. “Withdrawing from a portfolio means determining the right mix of tax-deferred, tax-exempt, and taxable accounts to withdraw from in order to minimize tax liability.”
Financial professionals generally recommend tapping your taxable brokerage accounts first, leaving your tax-deferred accounts to continue delivering growth for longer.
Withdrawals from your brokerage accounts are taxed at your ordinary income tax rate, which may be temporarily lower in the early years of retirement before Social Security and/or required minimum distributions (RMDs) kick in for your tax-deferred accounts. Thus, it could potentially be wise to make larger withdrawals from taxable accounts during your lower income years to take advantage of your lower tax rate.
When you turn age 73, you will be required to begin taking required minimum distributions (RMDs) from your pre-tax retirement accounts, such as your 401(k) and traditional IRA. Because those dollars have never been taxed, you will owe ordinary income tax on the amount you withdraw. RMDs may also bump you into a higher tax bracket, depending on the size of your account. (Learn more: Turning 73? Required minimum distributions explained)
Withdrawals from your tax-free accounts, including your Roth IRA, should generally be left for last because they are not subject to RMDs and can continue delivering tax-free growth for as long as you live, which may help boost your portfolio balance.
Retirees should consult a tax expert or financial professional before making decisions about their withdrawal strategy.
Asset location/tax diversification
You can potentially maximize your retirement income further still by being strategic about where you park your investments within your portfolio, an investing concept known as asset location. (Learn more: Asset location strategy: Tame your taxes)
As a general rule, financial professionals suggest that investors hold their most tax-efficient assets in their taxable brokerage accounts. Those assets include:
- Municipal bonds, which usually don’t incur federal taxes.
- Tax-managed mutual funds.
- Passively managed exchange-traded funds (ETFs).
- Index stock funds, which typically have low turnover so they are less likely to incur capital gains that get distributed to investors.
- Your less tax-efficient assets may be best suited for tax-exempt and tax-deferred accounts, such as your 401(k) or IRA. Those include:
- Stocks that pay dividends.
- Active mutual funds with high turnover rates.
- High-yield corporate bonds.
- Bond funds that generate taxable interest payments.
- Real estate investment trusts.
An effective asset location strategy can potentially pay dividends, especially for retirees who hold the majority of their savings in 401(k)s or other tax-deferred accounts. A hypothetical 65-year-old retiree with $150,000 (5 percent of their portfolio) held in tax-exempt accounts, $350,000 (12 percent) in taxable accounts, and $2.5 million (83 percent) in tax-deferred accounts such as a 401(k) could conceivably save $56,000 per year in taxes — or $1.4 million total over 25 years — by simply relocating their assets to reflect the following:
- $1.02 million (34 percent) in tax-exempt accounts.
- $990,000 (33 percent) in taxable accounts.
- $990,000 (33 percent) in tax-deferred accounts.
Both portfolios would generate annual income of at least $200,000. That calculation assumes the retiree pays 20 percent in capital gains and 40 percent combined in federal and state ordinary income tax.
Adding annuities for guaranteed income stream
Annuities, which can help cover the gap between your living expenses and your guaranteed sources of income such as Social Security and any pensions you may have, are another way to potentially juice your retirement income.
Why? Knowing your monthly bills are covered may enable you to invest more aggressively for growth. An annuity provides guaranteed income in exchange for a payment or series of payments made to an insurance company. (Learn more: Different types of annuities explained)
A 2024 case study by BlackRock found that adding guaranteed lifetime income with annuities, combined with a more aggressive asset allocation, could potentially generate 29 percent more in annual spending ability from retirement savings (excluding Social Security). It also reduced downside risk by 33 percent, according to its portfolio simulations.2
BlackRock’s research analyzed the potential impact of using a combination of financial tools to enhance a hypothetical retiree’s portfolio mix of 60 percent fixed income and 40 percent stocks.
“Having a portion of their future income needs fully guaranteed by annuities frees up the retiree to increase their equity allocation from 40 percent to 50 percent,” the BlackRock report found. “Nonetheless, overall retirement income risk remains relatively neutral, as the 50 percent equity allocation is applied to only 70 percent of total assets (due to the 30 percent allocation to the annuities).”
An annuity, however, may not be right for you depending on your assets, time horizon, and financial goals. A financial professional can help you create a personalized plan.
Your cash cushion
As with those who use annuities, retirees who maintain a cash cushion or emergency fund large enough to cover their living expenses for at least one year, may also be better positioned to create more retirement income.
A financial safety net from which to draw during stock market downturns gives their portfolio time to recover, so they aren’t forced to lock in losses. It may also permit them to assume greater risk in their asset allocation and reach for higher returns.
Permanent life insurance, including whole life insurance, can potentially be one source of cash, said Drabinski.
Such protection products first and foremost provide a guaranteed death benefit to your heirs to help them maintain their standard of living after you pass away. (Learn more: How life insurance can help supplement retirement income)
But permanent life insurance policies also accumulate cash value with every premium payment, money that is available to policyowners during their lifetime penalty-free to pay for anything they might need. (Related: Life insurance: Treat cash value with care)
Be aware, however, that borrowing from cash value will reduce the policy's cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.
Asset allocation
Your asset allocation, or the mix of stocks, bonds, and cash within your portfolio, is dictated by your tolerance for risk and financial goals. And it largely determines your investment return.
“There have been tons of studies on this topic, but the vast majority of them say that asset allocation accounts for somewhere between 80 percent to 93 percent of the difference in investment returns between two different portfolios,” said Pearson.
Retirees often, appropriately, become more conservative with their asset allocation as they enter wealth preservation mode, moving more of their portfolio into bonds which offer less upside potential but also (historically at least) lower risk. A blend of 40 percent bonds and 60 percent stocks is typical for many retirees.
But some become too conservative too early, shifting too much of their portfolio to bonds or cash. That may result in a loss of purchasing power due to the corrosive effects of inflation, which could increase their risk of outliving their savings.
To balance growth potential with short-term stability, financial professionals suggest that retirees who rely on their income stream for living expenses maintain at least some exposure to stocks that have the capacity to beat inflation.
To stabilize their portfolio returns, they should also ensure that their holdings include a diversified blend of stocks from different sectors, and market capitalizations (large capitalization, mid-capitalization, and small-capitalization), international stocks, commodities, real estate, and alternatives.
Conclusion
Retirees who want more spending money to enjoy their golden years need not sit on the sidelines.
By optimizing for key variables, including Social Security benefit timing and tax efficiency, they can potentially enhance their retirement income without increasing their odds of outliving their savings.
Discover more from MassMutual…
Beware retirement’s overlooked risk: Sequence of returns
Don’t have an emergency fund? Get one
Need a financial professional? Find one here
________________________________________
1 Vanguard, “Show clients that, yes, they can spend more in retirement,” May 15, 2024.
2 BlackRock, “How to optimize retirement income,” 2024.