Financial Literacy - Retirement Income Planning
How to create a retirement income stream

Failure to take those distributions or withdraw a large enough amount results in a hefty 50 percent excise tax on the amount not distributed. It should be noted, though, that a new law passed in December 2008 waives the required minimum distribution for the 2009 tax year only, due to the recent market decline.

The third and final bucket includes your tax-free accounts, such as a Roth IRA. This is funded with after-tax dollars so earnings are tax-free once you reach retirement age. It's generally recommended investors tap these accounts last, since there are no minimum withdrawal rules for a Roth and your earnings will continue to grow tax-free.

The other benefit to leaving your Roth for last? Roth IRAs provide valuable estate planning benefits since your heirs will not owe taxes on an inherited Roth and they're able to spread out their withdrawals over their lifetimes, allowing the account to continue its tax-free growth.

Be mindful of taxes

Keep in mind, however, these withdrawal strategies are merely guidelines.

Some studies suggest that a more managed approach, which accounts for tax law changes, can improve the sustainability of your portfolio.

Horan's study for the Journal of Financial Planning, for example, finds that in a tax rate environment characterized by variability, making traditional IRA withdrawals when tax rates are low and Roth IRA withdrawals when rates are high performs "especially well."

"Because distributions from traditional IRAs are taxable and those from Roth IRAs are not, it is advantageous to make withdrawals from traditional IRAs when the tax burden is light and to make withdrawals from Roth IRAs when the tax burden would otherwise be heavy," he writes, adding that retirees "can benefit from having multiple types of tax-advantaged retirement accounts from which to draw" during their retirement years.

The study further concludes that if your IRA distributions comprise the bulk of your retirement income, your withdrawals will likely be subject to a series of progressively higher tax rates in any given year.

Because taxable distributions can be applied against personal exemptions, deductions or lower tax brackets, the strategy of withdrawing from the traditional IRA first produces substantially larger portfolio accumulations over time, Horan says.

Better yet, take traditional IRA distributions that would be taxed at rates up through 15 percent and satisfy the remainder of the required minimum distribution from your Roth IRA. Such a strategy "yields residual accumulations that are 20 percent to 40 percent greater than" selecting a single account to tap (and deplete) first, he found.

Translation: Your money will last significantly longer if you take a blended approach to meeting your required minimum distributions.

"Retirees can significantly improve the sustainability of their retirement portfolios by embarking on an optimal withdrawal program," Horan says.

"I'm not a prophet with respect to future tax rates, but conventional wisdom suggests that we have no choice but to raise taxes going forward because of recent commitments made (by President Barack Obama) and the state of the economy," Horan says. "So if you think rates are going to be higher in the future, then that would argue for taking some of your taxable distributions (from a traditional IRA or tax-deferred retirement plan) now before rates go up."

Consider Social Security

Yet another decision facing the newly retired is when to begin drawing Social Security.

The earlier you collect, the less you receive.

For example, the minimum age for drawing Social Security benefits is 62, but you receive a permanently reduced benefit by collecting before your full retirement age, which ranges from 65 to 67 depending on the year you were born.

Social Security benefits by age
The longer you wait to collect Social Security benefits, the more you receive. If your full retirement age is 67, the reduction for starting your Social Security at age:
  • 62 is about 30 percent
  • 63 is about 25 percent
  • 64 is about 20 percent
  • 65 is about 13.3 percent
  • 66 is about 6.7 percent
Source: Social Security Administration

At full retirement you are eligible to receive 100 percent of your benefit, but you can delay benefits even longer if you choose, making the size of your Social Security checks larger still -- up until age 70.

Most financial planners recommend delaying benefits as long as possible, especially if you undersaved for retirement because Social Security is your last, best chance to boost your income.

But that only makes sense if you're healthy. If you're facing a significant reduction in life expectancy due to illness and you need the money, it may make sense to begin collecting Social Security as soon as possible, despite the reduced benefit.

Remember, too, that if you continue to work during retirement, you must consider your income to determine whether it's wise to claim Social Security or wait until you quit.

According to the Social Security Administration, if you have substantial outside sources of income (either from wages, self-employment, interest or dividends), you may have to pay federal income tax on your Social Security checks -- up to 85 percent of your benefit.

If you file a joint return, for example, and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits. If you make more than $44,000, up to 85 percent of your benefits may be taxable.

You can lower your taxable income during retirement by taking proceeds from both taxable accounts and Roths, which in turn helps minimize the taxation of your Social Security benefits, says Adams.

As you map out your retirement withdrawal strategy, make sure you take the time to understand the rules, penalties and tax liabilities associated with each of your accounts.

And don't forget, the trick to making your nest egg last is not the size of your account, but how well you manage what you've got.

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