Saving for retirement can take the entire duration of a person’s working years. Whether through an employer-sponsored retirement plan, such as a 401(k), or personal saving and investing, or both, assets accumulated over many years can get one in a great position for retirement. This is referred to as the “accumulation phase” and is the first step in securing a successful retirement.
The second step is referred to as the “distribution phase,” or the planning for how to take retirement income from the various assets that have been accumulated. There is generally an accepted hierarchy of assets from which to distribute retirement income. Let’s review that hierarchy.
The first two are the easy ones – social security and required minimum distributions (RMDs) from retirement accounts, namely IRAs. How and when to take one’s social security is a lengthy conversation for another day, but the vast majority of Americas have paid into and will eventually receive social security benefits. Under current tax law, anyone born between January 1, 1951, and December 31, 1959, must begin taking their RMD by April 1 of the year following the year during which they turn 73. For those born on or after January 1, 1960, their RMDs must begin the April 1 of the year following the year they turn 75.
The third source of retirement income can be rental income if rental property is owned, especially property that is free of mortgage debt. Since most rental agreements include a cost-of-living adjustment, the investor, in effect, gets a raise every year.
The fourth source of retirement income would be from non-qualified assets. There are often referred to as personal savings assets and are specifically not retirement accounts. The primary reason is these assets are taxed upon distribution only to the extent of accumulated capital gains. Basis, or the amount invested in the account from after-tax assets, is received tax-free since these assets have already been taxed. You can even control the amount of taxable distributions by carefully selecting the assets that are sold to generate the cash to distribute.
The fifth source is from qualified retirement assets above and beyond what is their RMD. These distributions are fully taxable as ordinary income which is typically taxed that the individual’s highest marginal tax rate. Here, too, these taxable distributions can be combined with income from other sources to control the amount of taxable income.
Lastly, distributions from Roth IRAs. Why last to distribute, especially when these distributions are received tax free assuming certain qualifications are met? Primarily because Roth assets accumulate tax-free and do not have RMDs for the original account owner.
In many cases, the retiree can plan to take their retirement income from several sources noted above simultaneously to create a retirement income plan that meets their current needs, controls the amount subject to current taxation, and that can preserve assets for the next generation. Note that there are always special circumstances in every case and should be considered before creating a retirement income plan.