How to Map Out Your Supplemental Income

Good Morning Relaxing Retirement Member,

Last week, we talked about the two key factors you need to consider before deciding which investments you should withdraw first to supplement your social security and pension income.

Should you withdraw money from your IRA?  Sell stocks?  Cash in CDs?  Spend the interest and dividends on your bonds and bond funds?  Begin drawing down your tax deferred annuity?

You may recall that 2 factors to consider are:

  • Your IRA Required Minimum Distribution (RMD): the amount The IRS mandates that you withdraw from your IRA and pay taxes on when you reach age 70 ½, and
  • Negative Income: the amount of “taxable” income that you can earn before the IRS begins taxing you. ($18,700 for couples under age 65, and $19,700 for couples age 65 and older)

Knowing these two pieces of information, here are some strategies to consider given your own unique set of circumstances:

  • Use a minimum of a 10 year time horizon to plan. This may sound overly simplistic, but most people, if they plan at all, only plan one year at a time.
  • Plot your supplemental income needs over the next 10 years, and know “when” you’ll need the money:
    • Although it’s impossible to predict all financial needs over the next ten years, you’d be surprised how close you can come.
    • To start with, you must be crystal clear on the amount of “fixed” income that you will receive over the next 10 years from social security and pensions.  And, if they are subject to cost of living increases.  Most pensions do not have cost of living increases built in.
    • You also must be crystal clear on what it costs you to live the way you want.  Fixed expenses like real estate taxes, groceries, utilities, and insurances are easy to tally.  What most people fail to accurately get a handle on are their ‘discretionary’ expenses like vacations, meals out, and presents for your grandchildren.
    • The “difference” or “shortage” between the two is the amount that you will need to withdraw from your investments.  I can’t stress enough how important it is to know this number.
    • Concerning “when” you’ll need the supplemental income, you may have no need for a new car right now for example, but you know you’ll need to buy a car sometime in the future.  Knowing “when” you’ll need the money to do it allows you to plan ahead right now so you can take the money from the most advantageous place.  And, as a side benefit, it decreases your anxiety when it comes time to buy the car.
  • Knowing this information, here are Critical Questions you MUST know your
    answers to
    • “If you turned age 70 ½ today, what would your IRA Required Minimum Distribution be?” (Don’t wait until you turn 70 ½ to find out.  You need to know right now.)
    • Will your IRA Required Minimum Distribution (RMD) be GREATER than your supplement income need?”
      • For example, if the IRS mandates that you withdraw and pay taxes on $25,000 per year, but you need and are already withdrawing $50,000, you’re already satisfying the minimum requirement.
      • However, if you only need $25,000, but your Required Minimum Distribution is $50,000, you’ve got a problem because you’re going to have to withdraw and pay taxes on more money than you want to.  In this case, some planning is needed.
  • Consider withdrawing some money from your IRA before you turn age 70 ½. Why?
    • You may be able to pay no income taxes on the amount you withdraw (using negative income as I outlined last week and/or tax credits)
    • Potentially pay taxes at a lower tax bracket than you would when you are required to withdraw more later.  If you can withdraw an amount and only pay taxes at the 15% marginal tax rate as opposed to paying taxes at the 28% or 35% marginal tax rate later, you may be better off withdrawing some now before you turn 70 ½.
    • It reduces your need to withdraw as much when you do reach age 70 ½.  If you withdraw some now, the balance of your IRA will be less when you reach age 70 ½ and thus, you’ll be required to withdraw less at that time.
  • Given the choice and your allocation strategy, consider holding your fixed income (bonds, CDs, etc.) investments inside of your IRA as opposed to your equity (stock) investments.  Why?
    • In the long run, fixed income investments typically do not grow as fast as stocks, so your IRA may potentially not be as large when you reach age 70 ½.  The bigger your IRA, the more you are mandated to withdraw and pay tax on.
    • Instead, have your equity investments held outside of your IRAs where they also have the opportunity to take advantage of capital gains tax rates (currently a maximum of 15% at least through the end of 2010 unless extended) vs. ordinary income tax rates (currently a maximum of 35%) on the same gains.  Wouldn’t you rather pay 15% than 35%?

As you can see, there is some serious planning that goes into this.  But, the benefits are
worth it.

Don’t just lazily withdraw money from wherever it appears to be most convenient at the time. 

Take the time to plan.  It could mean the difference between your money running out too soon vs. lasting as long as you need it to.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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