Retirement income planning: 4 steps to take

You want to be fully prepared with a well-designed income strategy before you enter retirement. The time to start planning is now.

One of the most significant transitions in life occurs when you retire from work. You'll no longer be able to rely on a paycheck or regular income stream. Going forward, you’ll be required to generate cash flow from a variety of sources you’ve already established, then make sure that money can meet your needs for what could be decades.

Even before you retire, it’s important to establish a comprehensive plan that identifies available sources of income and your projected living expenses in retirement. These four steps can help you work toward a defined retirement income plan for spending and saving.

1. Assess your income needs for the long run

Your living expenses may evolve over the course of retirement, but for starters, you want to try to spell out what your first year expenses will be. These can be separated into two categories – essential expenses and discretionary costs.

Essential expenses are those that you want to be sure you have enough income to meet throughout your life, including:

• Housing costs: Your rent or mortgage payments, plus insurance, taxes and ongoing maintenance.
• Day-to-day living expenses: Make sure you’ve allotted for food, clothing and utilities.
• Taxes: Depending on how your retirement accounts are structured, you may need to pay taxes on withdrawals. A portion of your Social Security income may also be subject to tax.
• Healthcare needs: This is typically one of the larger retirement expenses, and Medicare only covers part of it. You should consider, and prepare for, the possibility of unforeseen health issues that could require out-of-pocket costs.
   

Discretionary expenses are funds used for purposes such as travel, entertainment, hobbies or other non-essential expenses that are designed to enhance your quality of life in retirement.

It’s important to remember that many of your living costs will rise over time. Most categories of expenses are subject to the impact of inflation. Some, such as healthcare, may rise much more significantly, particularly as you grow older and health issues become more significant.

2. Identify all sources of income

You will draw income from a variety of sources in retirement, so it's important to be aware of how taxes will impact the net income generated from each:

• Taxable or tax-preferred accounts: Your savings and certain investment (brokerage) accounts can provide income that may be taxable or in some cases, are sources of income where taxes have already been paid. Social Security benefits may be subject to taxation depending on your circumstances. 
• Tax-deferred accounts: Traditional IRAs, workplace savings plans such as 401(k)s, pension plans, deferred compensation payouts and annuities provide income that is subject to current tax.
• Tax-free accounts: Income from municipal bonds, Roth IRAs, life insurance cash values and Health Savings Accounts (HSAs) are all available on a tax-free basis, assuming certain requirements are met.
   

You'll ideally be able to draw income from all three of these categories. That will help you more effectively manage your tax burden and may help you meet income needs throughout your life. Read more about tax diversification and investing.

3. Re-position your portfolio

As you close in on retirement, it’s important to begin adjusting your portfolio. Your focus is changing. The emphasis is no longer on accumulating wealth but instead on generating income over your lifetime. Your risk profile should be adjusted to reduce the impact of potential market volatility in your portfolio.

Consider positioning a portion of your portfolio in assets subject to minimal fluctuation. These are dollars that will be used to meet your more immediate income needs (in the next five-to-seven years). The remainder of the portfolio can be invested with the objective of generating additional growth to help meet future income needs.

Matching specific assets to various types of accounts (taxable, tax-deferred and tax-free) can help improve the efficiency of your portfolio.

4. Establish a withdrawal plan and strategy

When it comes to withdrawing money from your accounts, there are a variety of withdrawal strategies to consider.

Regardless of the approach you choose, you may want to match specific income sources to certain types of expenses. For example, you can target income from reliable sources such as Social Security, a lifetime annuity, pension income (if available) and required distributions from IRAs or workplace savings to cover essential living expenses like healthcare, food, housing and taxes.

At least 80%, and ideally 100%, of essential expenses should be covered by predictable retirement income sources such as these. That gives you the freedom to use your traditional investment-oriented portfolio to cover discretionary income needs, such as travel, entertainment or a major, life-enhancing expense.

Remember that taxes are an additional consideration. It’s important to budget for taxes that will be deducted from your income as you plan your retirement income strategy.

Stay flexible

The most important thing you can do for your retirement is start planning now. Creating your comprehensive plan, which accounts for where you are today and where you want to go, will give you milestones to work toward.

Your plan won’t be permanent as your situation, expenses and goals will likely change throughout your career and retirement. Meet with a financial professional at least annually to review your plan and how it’s working for you.

Download our retirement income planning checklist. 

Get more information on saving, preparing for and living in retirement in our retirement planning toolkit.