Which Account Should I Use for Cash Flow in Retirement?

If you think that saving for retirement is hard, wait until it comes time to spend it. When you are working and making contributions to a retirement plan, it’s pretty easy. You open a retirement account, contribute to it regularly, and off you go. If you are lucky enough to have a company-sponsored plan, you make your deposits into the account via payroll deduction.

Oh sure, you will have to actually sign up for the retirement plan. And you will have to make decisions about a few things, but it’s pretty easy. When you open the account, you will name a beneficiary who will inherit the assets if something happens to you. Next, you’ll have to decide how much to contribute to the account. I would suggest that you shoot for at least 10% of your gross pay, but anything is better than nothing. If you are really lucky, your company will match your contribution—that’s free money! Make sure you are contributing at least enough to get the full company match. Finally, you’ll need to make decisions about how your account is invested. Often, when just starting out, a target retirement date fund is a good choice.

That’s it! Pretty simple. During your working years, you’ll hardly notice the retirement account. But boy, do you start paying attention to it when it comes to start spending it. Going from living on a regular paycheck to living off of your retirement funds is often more difficult than saving is! In last week’s post, Are You Living Too Frugally, I discussed how we are seeing a trend of older clients holding on to a big pile of money and underspending in their retirement years. I believe the perfect retirement plan ends with a bounced check to the funeral service. Just kidding. Sort of.

When you look to replace your paycheck, you must consider your resources and start to develop a plan of action. Usually there will be Social Security income and maybe a pension. The rest of the cash flow that you need to fund your lifestyle will have to come from your savings. Hopefully, you’ll have some after-tax savings—maybe cash you received when you downsized and sold your longtime home. You might have an IRA or a 401(k) or 403(b) from your working years. Maybe you have a Roth IRA. More and more people do.

The question then becomes “What’s the best way to take money out of my accounts?” The answer, like most answers in the financial planning world, is “It depends.” In the above scenario, our fictitious retired couple has three buckets of money to choose from. They have their after-tax money from the sale of the house. This money has already been taxed at some point, and any cash flow that comes from this bucket is not taxable again, except for the interest, dividends, and capital gains the investments generate. Our couple also has a bucket of tax-deferred money, which comes from their IRA, 401(k), or other retirement accounts. Any cash flow coming out of these accounts will be taxed as ordinary income. Finally, they have a couple of Roth IRA accounts that they funded in the years leading up to retirement. This gives them a bucket of tax-free money.

By managing which bucket you take money out of to fund your cash flow needs, you can, to some degree, control the tax consequences of your retirement income. For example, you might want to take distributions from your post-tax bucket first. Any cash taken from this account is not taxable, except for tax that may be due on the interest, dividends, and capital gains. But that’s generally OK because capital gains tax rates are lower than ordinary income tax rates. And, depending upon your tax bracket, they may be tax-free.

If you are taking distributions from your retirement account, those funds are considered ordinary income. Monitor how much you are taking, and if you are getting close to moving into a higher tax bracket and still need cash flow, you can take some distributions from the tax-free pile, your Roth accounts.

Please remember, the example above is just that—an example. It is not a recommendation. We do, however, recommend that everyone review their individual situation by doing some tax planning. Having a distribution plan in place can help you get the cash flow that you need while lessening the tax bite on those treasured retirement dollars.