When planning retirement, one of the most crucial but often overlooked questions that individuals neglect to think about is “how to pay for retirement.” How will you generate cash in retirement when you are no longer earning the full-time salary you were accustomed to making?
The answer is not an easy one. There is not a one-size-fits-all solution. There are several options to choose from, all of which have different advantages and disadvantages. Since the answer is different for everybody, it’s important to understand the options (and consequences) to make the best decision for your future.
6 Ways to Pay for Retirement
Here are six different sources, in no particular order, that may provide you with cash in retirement to help you meet future cash needs:
- Social Security
- Part-Time Work
- Pension Income
- Distributions from Retirement Accounts
- Bank Accounts
- Brokerage Accounts
The first three sources – Social Security, Part-Time Work, and Pension Income – are discussed here.
The remaining three sources – Distributions from Retirement Accounts, Bank Accounts, and Brokerage Accounts – are discussed in detail in part two of our series, How to Pay for Retirement (Part Two).
Let us start with the first option most people think of when asked how they will pay for retirement: Social Security income.
Advantages to Taking Social Security Benefits
There are several advantages to taking social security income immediately upon retirement. They are as follows:
- Social Security provides a monthly reliable income stream.
- Distributions may be tax-free or less taxable compared to other sources of retirement distributions.
- It may allow you to delay taking other sources of retirement income that can increase over time.
- It’s easy to have benefits automatically transferred to your bank account.
The most significant advantage to taking social security benefits first is that by doing so, you can delay taking distributions from other retirement sources, such as your IRA or 401(k) accounts. Delaying having to take distributions from retirement accounts allows those funds to continue growing tax-deferred (or tax-free in the case of a Roth IRA). Additionally, you will pay less tax on social security income than you would on retirement distributions (other than a Roth IRA).
As an example, let’s say a 65-year-old married couple decides to live off their social security income. This would allow the couple’s retirement accounts to continue to grow until they reach age 72, at which time the IRS mandates they take required minimum distributions.
For some people, social security will not cover all their expenses. That’s okay. Every dollar that is covered by social security reduces the amount that needs to come from other sources.
Disadvantages to Taking Social Security Benefits
There are several disadvantages to tapping into your social security benefits immediately upon retirement, such as:
- You receive reduced benefits if withdrawals occur before your Full Retirement Age.
- Withdrawals may be less tax-efficient than from your bank or brokerage account.
- Social Security benefits are not likely to keep pace with inflation.
Social security benefits are permanently reduced if you begin withdrawals before reaching your Full Retirement Age. This may significantly affect your ability to keep pace with inflation, especially later in life. With life expectancy getting longer, this can create a more significant gap between your Social Security benefits and your cash needs. As you get older, this shortfall will continue to grow, forcing you to tap other sources to provide you with sufficient cash in retirement.
Social security benefits increase most years, but the formula used to determine the increase can be much different (lower) than the inflation you are experiencing.
Even if you decide to wait to collect benefits, it is wise to plan for the day when you will need to supplement your cash needs with something other than social security income.
Working part-time can be another solution to ensuring you have enough cash in retirement. This can mean a “phased-in” retirement where you slowly reduce the number of hours or days at your current job, or it could mean a new position for fewer hours (and less pay) someplace new.
Advantages to Working Part-Time After Retirement
There are advantages to working part-time after retirement to help pay for retirement.
Potential for Investment Growth. Generating an income (even a modest one) may allow for the delay of distributions from retirement plans and brokerage accounts, giving those funds more time to grow.
Increases Social Security. This strategy allows you to accrue a larger social security income by delaying the collection of benefits until age 70. Benefits increase 8% per year for every year you postpone collection beyond full retirement age. Continuing to work can also increase your benefits if you have not already maxed out on the number of working years Social Security looks at to determine your benefits.
Smooths Transition. Last but certainly not least, working part-time after retirement can help smooth your transition into retirement. A phased retirement where you gradually stop working can help you deal with the emotional impact of entering the next phase of your life. For some people, the thought of working today and being fully retired tomorrow with nothing to do can be a bit daunting. Phased retirement allows you to take a test drive to see if you enjoy not working.
Disadvantages to Working Part-Time After Retirement
There are a few disadvantages to working part-time after retirement.
Work-Life Balance. Working part-time may not allow you to do some of the things you had hoped to do once you retired. For example, it could impact the amount of time you spend traveling, taking up a new hobby, or visiting family. That said, flexible work arrangements are more common now than ever before. Many companies offer employees flexible hours and work-from-home arrangements to make it easier to achieve an acceptable work-life balance.
Taxes. The taxes you pay on earned income (even part-time) are higher than the tax you pay on other forms of income you may choose to take in retirement. Earnings are taxed at ordinary income tax rates and are subject to FICA taxes (Social Security and Medicare) of an additional 7.65%.
Aging. Finally, it’s important to remember that part-time work after retirement is likely a temporary solution. Over time, your appetite to keep working may wane, and at some point, you may be unable to work (physically or mentally).
If you have a pension and have already reached your Full Retirement Age, deciding when to start taking the pension is quite simple. The starting date is usually outlined in the pension plan document and will begin upon separation of service for retirees who have reached a certain age, for example, age 65.
But what happens if you retire before the retirement age outlined in the plan? You’ll need to decide if you should start collecting your pension early to help pay for retirement or wait until you reach the documented age.
Advantages to Collecting an Early Pension
Taking an early pension can do the following:
- It may allow you to delay taking other sources of retirement income that can increase over time.
- It provides a monthly and reliable income stream.
- It’s easy to have money automatically transferred to your bank account.
- Pensions provide favorably for a surviving spouse.
Allows for Investment Growth. Pension income is another source that enables you to delay withdrawing from other accounts. For example, if you have a pension, Social Security, and a part-time job, you could earn as much, or even exceed, what you were making before retirement. If you are fortunate enough to be in this position, you may be able to allow your retirement accounts to grow for a long time before needing to withdraw from them. We’ve even seen clients have to withdraw IRA and 401(k) money they don’t need, simply because they reached age 72, when minimum distributions become mandatory.
Provides a Reliable, Easy-to-Access Income Stream. Pensions are usually paid once a month, on the same day each month. This steady income stream can be comforting if you have recently stopped working. Most pensioners have the monthly amount transferred directly into their bank accounts, making it even easier to access the needed funds.
Provides Favorably for a Surviving Spouse. Choosing the appropriate beneficiary designation can result in the pension being paid to your spouse after you die. This becomes critically important since the amount of social security income that the surviving spouse will receive will decrease.
Disadvantages to Collecting an Early Pension
When considering if you should collect your pension early, be aware of these disadvantages:
Loss of Purchasing Power. Most pensions are not adjusted annually for inflation. With a planned retirement of thirty years, that is a significant loss of purchasing power.
Taxes. Pension income is taxed at ordinary income tax rates. Still, unlike part-time earnings, no FICA tax is collected on pension income. State taxation of pension income varies from state to state. Some states do not tax pension income or provide an exclusion for a portion of the benefit. New York and New Jersey do give some tax relief for pension income collected.
Collecting your Social Security income benefits, finding part-time work, and drawing on a pension income are three viable sources to help you pay for retirement. If you’d like to discuss the advantages and disadvantages to each of these methods, or learn how they work together to provide you with enough cash in retirement, feel free to call one of our wealth advisors.
In How to Pay for Retirement (Part Two) of this series on raising cash in retirement, we discuss three more ways to help you pay for retirement: Distributions from Retirement Accounts, Bank Accounts, and Brokerage Accounts.