Taking the proper steps early to prepare yourself for one of life’s biggest transitions can alleviate much unwanted stress and…save you money.
The first step in preparing for retirement is determining if you are actually ready. In this episode I go over what you can do to determine your retirement readiness along with a host of other important financial planning considerations.
More specifically, I discuss:
- “Practicing” retirement
- The importance of an emergency fund specifically for retirees, and how to structure it
- Cash savings ideas to implement tax savings strategies while in retirement
- Various types of retirement income, and how to structure them to meet your needs
- Understanding YOUR tax situation in retirement, and how taxes affect your income sources
In part 2 of the Preparing for Retirement series we will continue the discussion with:
- Tax withholding on retirement income sources and estimated payments
- What to do with retirement accounts
- Healthcare near retirement and Medicare decision
- The timing implications of your retirement from the workforce and last minute considerations
Resources From This Episode:
Related Episode: Preparing for Retirement Pt. 2
Related Episode: What is a Roth Conversion, and Why Should I Consider It?
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Checklist: What Issues Should I consider Before I Retire - 2022
Preparing for Retirement Part 1
[Fun, Upbeat Rock Music]
# YOU NEED GUIDANCE, STRATEGIES TO USE, YEAH. I’M GONNA SHOW YOU HOW TO DO THIS. INVESTING AND TAX, ESTATE TIPS YOU NEED, YEAH. I'M GONNA GIVE YOU MY HELP. I'M GONNA GIVE YOU MY HELP. OH!
Welcome to Retired-ish. A podcast produced for those exploring retirement and those currently in retirement. I'm your host, Cameron Valadez, and today I want to go over the laundry list of important things you will need to consider before you decide to stop collecting a paycheck. Even though this podcast is about the concept of retirement. Retirement is not a one-time event but rather a new phase of life, a shift in lifestyle if you will.
It doesn't mean to literally stop working and never work again, although that is part one of the retirement phase for most. Your retirement could be whatever you want it to be. Whether you semi-retire and work a little less, or maybe even switch careers and do something else that interests you, whether there's a paycheck attached to it or not.
For a lot of us, our work is our identity and our hobby. Maybe you never truly stop “working” in some capacity. Everyone is different. When I reference retirement, I simply mean a transition to a new phase of life where you spend significantly less time working and more time on other discretionary things you enjoy.
Either way, your retirement will be some sort of transition from the day-to-day norms that you've been accustomed to for so many years into a different lifestyle. And regardless of what you do next, there are several things you'll want to consider before making the transition. So, let's dive in.
First things first, ask yourself this question. Are you actually ready to retire? This is a question I want you to ask yourself a few times on different days and when you're in different moods. I can't emphasize how crucial this is because, as human beings, we largely make decisions emotionally rather than rationally. We are irrational beings. While your personal reasons to retire may be overwhelming, there's often more to the decision than you initially think.
Such as you've been at it for over 30 years, there's no more upside, and you're spinning your wheels. All of your friends have just retired, or now you have grandchildren. The list goes on. But the first question I always ask clients who think they are ready to retire is, what will you do with your time? I mean, think about it, other than a one or two-week vacation, basking in the sun on some island somewhere, have you felt what it's like to wake up every day without a plan? Likely not in a very long time.
Most people have a list of things that they want to do when they retire, but those are usually short-term desires, like traveling to another country for a few weeks, which is okay, but what about the other 300 or so days of the year?
A good example of this is a client of our firm who retired after a very long and rewarding career as an aerospace engineer. He left the company he worked for at around age 64 and immediately filled his time with a couple of the hobbies that he already had. It didn't take long, only about a month or so into the transition, he decided to go back to work in the industry, however, this time with a competing company.
So why did he do it? I mean, he knew it wasn't about the money at this point. It was because even though he had hobbies, he realized that they didn't take up that much time out of his day. He also felt a loss of feeling important. No more daily emails and calls filling up his inbox from anyone who needed his expertise or wanted his input.
So, he found that with a little better time management, he would be able to enjoy his hobbies and still practice his passion. He realized that the application of his skills was his biggest and most passionate hobby. Now, this, of course, isn't the same situation for everyone. Some people are like, ‘Hey, I’m done. I'm out. Sayonara.’
But before you officially decide to leave the workforce, think about your family, your spouse, or your kids. What situations will they be in? Let's take my in-laws, for example. My father-in-law is a proud retired fireman who is nearly 10 years older than my mother-in-law, who's an accomplished former psychologist.
He retired around the young age of 50, as most firefighters often do. My mother-in-law originally planned to work between the ages of 55 and 60 due to her profession. However, once she reached her early fifties, so nearly 10 years after my father-in-law retired, she began to realize that their time to enjoy the finer things in life together is diminishing faster than she originally thought because of the age gap. Therefore, she decided to retire earlier than initially planned, giving up some financial benefits and her identity in order to live a more meaningful life for the two of them. The point is that you'll want to step into the shoes of the retired version of you before committing to that first step.
Now, there are several ways you can do this, but my favorite way you can do this is to give retirement a test drive. The only way to truly know how it feels is to experience it yourself. Me, nor anybody else can tell you exactly how it will be. As an example. You can do this trial run by maybe banking as much vacation days as possible to try to take three to four weeks off all at once. Oh, and here's the caveat. You can't actually go on a trip somewhere. You are trying to replicate the majority of your days in retirement. Now I know you're already telling yourself there's no way you're going to use up those hard-earned vacation days and not go somewhere awesome. But trust me, this exercise will be priceless for you.
It will tell you so much, and you'll learn a lot about yourself. You'll also need to be completely, and I mean, completely disconnected from work. So, no emails. Delete your email app or whatever you have to do to get rid of it for the time being. If you own a business and don't think you can manage taking that kind of time off, the reality is you likely can, but you just haven't done it before because you don't trust it.
My answer to you would be to start delegating more of your day-to-day duties and trust those wonderful, smart employees of yours. They can handle more than you think. You'll be surprised by the things they can figure out how to handle when they have no other choice.
Okay, so what about the money before we get into where your income in retirement will actually come from, I want you to grasp one of the most important concepts in personal finance, which is the emergency fund. Most people pay no mind to this because it's a relatively basic concept, and to be honest, it's boring to talk about, but it's critical to your retirement.
An emergency fund is simply cash in a bank account, not in your investment accounts, that is accessible at a moment's notice in case of some sort of emergency. And not just medical emergencies, but for anything really, like your car tire blowing out or your AC unit suddenly goes bad in the middle of summer.
Now, I actually prefer you don't keep the emergency money in an account tied to a plastic card that you can wave around and use any time you want, but at least at a bank where you can quickly transfer the funds to an account with a card or walk into a physical branch and make a withdrawal. So, try not to put it in one of those online savings just to try to get a higher interest rate because it might be hard to get to when you actually need it.
So maybe use a separate savings account for your emergency fund at the same bank as your checking. Easy enough. Everyone's emergency funds will be different and for several different reasons, mainly depending on lifestyle.
You typically hear about the rule of thumb that states you need three to six months’ worth of living expenses saved in there, which is okay to use as a general guideline, but it gets deeper than that for retirees. For example, if you ride, say, dirt bikes as a hobby or go camping frequently in an RV, you're likely to have more one-off big expenditures or repairs for replacement parts than someone who crochets for a hobby. Nothing against crochet.
The reason why the emergency fund is so important for soon-to-be retirees is that it will serve as your insurance against being poor. Remember that you are likely to be on a relatively fixed income in retirement. The last thing you want is to not have an emergency fund or not enough of one and have a big unexpected expense come your way that causes you to use credit cards to cover the expense, use home equity, or worse, tap into a pre-tax retirement account before you plan to when it could have been avoided with a little preparation.
Not only will you pay high-interest rates on the borrowed funds from a credit card, but if more than one emergency comes up in a short period of time, you'll find yourself digging a hole of consumer debt that can become difficult or near impossible to get out of or worse, and eventual, bankruptcy. Yes, I said bankruptcy. Even in retirement, it happens more than you know.
At this point, you can't just simply go pick up some overtime to help cover those debts. That being said, if you have significant credit card debt before retiring, I would highly recommend getting that debt paid off before making a retirement transition, even if it means working for another few months.
You may also want to prepare a bigger pile of cash for reasons other than emergencies, such as planned expenses or to implement other financial strategies. For example, if you have a company-provided vehicle and leaving means you have to now purchase your own, or maybe you want to redo your kitchen and bathrooms now that you'll have more time, you don't wanna simply tap into assets like pre-tax, 401(k)s, and IRAs to pay for those things if you can avoid it because not only can taking lump sums from these accounts cause tax issues, but more importantly, it can decrease your portfolio's probability of success and providing you supplemental income throughout a possible 20 to 30-year retirement.
It may also be a good idea to begin building another separate cash reserve a few years ahead of leaving the workforce to help with other strategies, such as Roth conversions, for example. For those of you unaware, Roth conversions are where you convert money that hasn't been taxed yet in a retirement account such as a traditional 401(k), IRA, 457 plan, and the like, over to a Roth 401(k) or Roth IRA. The main benefit of this is that the money earned in a Roth-based account grows tax-free if a couple of simple rules are met. The caveat, however, is that the amount you convert is subject to taxation in the year of conversion.
For example, if you convert $50,000 in a traditional IRA to a Roth IRA in 2022, you will need to add $50,000 to your ordinary income and pay any income taxes due at tax time. A key thing to understand with this strategy is that it is preferred to pay that extra piece of the tax bill that's caused by the actual conversion from other cash or funds that you have saved outside of the retirement account itself. If you don't have other money saved, you can technically pay the additional taxes owed from the actual bucket of dollars that you converted from the IRA in this case, but that means that less money gets invested into the Roth IRA after the conversion, which is obviously less preferential since you now have less dollars growing tax-free.
For example, theoretically, if the tax bill on a $50,000 conversion is. $10,000, then $40,000 will go into the Roth IRA instead of the full 50, and $10,000 would be withheld for taxes. So, if you have done your due diligence and have done some financial planning ahead of retirement, you can actually save up cash to do planned Roth conversions when you get into retirement, and your tax rate is possibly lower. Then you'll have cash to pay the tax bill and can hopefully get all of those converted dollars into a Roth account to continue growing tax-free.
This is just one example, of course, but the key is to have a purpose to your cash savings since that money isn't working for you in earning much, otherwise. Don't worry too much about trying to find the bank account that pays the absolute highest interest rate, focus more on the purpose or goal of that money. So now that we understand the importance of an emergency fund and cash savings, let's focus on cash flow, which is money in and money out of the household. If you don't have it already, you will obviously need to have positive cash flow in retirement, but there are two ways of accomplishing this.
You either increase your income, which is tough if you won't be working in any capacity, or you can reduce expenses, which isn't necessarily that simple either, but it's easier and faster to do than increasing your income. Now I'm big into fitness and weightlifting, so I like to explain it like this. It's kind of like losing weight. You can either exercise more, which is harder or eat less, which is easier.
You'll also need to know the answer to several basic questions, such as how will you receive and manage your income? When will you receive it? How will it be treated for tax purposes and how much will you actually need, and therefore, what will your expenses be in retirement?
Obviously, the most important first step is knowing where your income will come from. This can be one source or many. However, it's always good to have diversified income streams if at all possible. Some example income sources could be Social Security income, potentially pension income for those of you fortunate enough to get one, passive income from things like real estate or royalties, investment income from liquid invested assets like 401(k)s, IRAs, non-retirement investment accounts, or maybe income from the sale of your small business.
One not-so-obvious thing to consider is the timing of these cash inflows or when you'll receive your income payments. Ask yourself which income streams will you have the ability to control.
For example, if you receive Social Security, your direct deposit will come in on either the second, third or fourth Wednesday of the month, depending on your birthday, so you don't necessarily have any control of the timing of those payments.
If you are also fortunate enough to receive a private pension, does that come in at a different time of the month or the same time as your Social Security? For instance, if two of your income sources come in around the same time, it is essentially like being paid once a month. But if you have been used to being paid every week or every two weeks for the majority of your life, this is going to require a bit more budgeting and self-control. Although it shouldn't be too difficult. If two income sources come in at different times, is one payment much less than the other? If so, this may require some additional budgeting since the income amounts may not line up with the various bills that you have.
Now, let's talk taxes. Since not all income sources are treated the same, taxes will arguably be by far your largest expense in retirement. So, it's important to understand your situation, at least on a basic level. Here are some basic tax concepts for common retirement income sources, starting with Social Security.
Social Security is taxable at the federal level and potentially the state level, depending on where you live. Currently, there are 12 states that do tax Social Security, and they are Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, and Vermont. As you can see, in most states, Social Security is not taxed.
You will want to be mindful of this if relocating in retirement and you'll be relying heavily on Social Security income. Now, even at the federal level, not all of your Social Security payment is subject to taxation, which is a good thing. The amount of your Social Security that is taxable is based on how much income you receive from other income sources, such as the ones I mentioned previously.
Essentially, the more other income you have, the more of your Social Security benefits becomes subject to taxation. The formula to determine how much is fairly complicated. Just know that either 0%, 50%, or 85% of your total Social Security benefit will be subject to federal taxation at your applicable tax rate.
So, for example, if you're in the 12% tax bracket based on all of your income and you receive gross Social Security checks of $2,000 a month, and 50% of your benefit is subject to taxation, that means that you'll pay 12% on $1,000, which is 50% of 2000 versus 12% on the full 2000. I hope that makes sense.
Income sources such as a pension income with the exclusion of some disability pensions, rental income from real estate, income from annuities, distributions from traditional IRAs, 401(k)s, and other employer retirement plans are all taxed as what is called ordinary income. This type of income is treated similarly to the income you receive when collecting a normal paycheck from an employer, but you're just no longer paying payroll taxes like FICA and unemployment tax.
Now, this income is taxed at whatever tax bracket you fall into and is also typically taxed at the state level if your state has an income tax. It is important to note that there are some states that do impose a general income tax, but income from pensions and or IRAs and 401(k)s those distributions may be specifically excluded.
For example, Mississippi has a progressive state tax system. However, pension income and IRA and 401(k) distributions are actually state tax-free. As mentioned, distributions from Roth accounts are eligible to be tax-free as well, as long as you meet the basic rules for your Roth contributions or any Roth conversions you may have done. Roth accounts are one of the only sources of tax-free income, which again is why they are so powerful. Just as a heads up, I've included a link in our blog in the show notes, which dives deeper into these rules for the Roth IRAs and Roth 401(k)s and how they may apply to your situation.
Lastly, you may have income from non-retirement investment accounts like transfer on death accounts, AKA TOD accounts, or trust accounts, for example. Any income earned from these types of accounts are subject to tax each year but are treated in various ways depending on the type of investments held. Taxes would apply on the state level as well. But again, only if your state has an income tax.
Some stocks pay what are called qualified dividends, which are taxed at the more preferential tax rates, which can be either 0%, 15%, or 20%. Income from other non-qualified dividends or income from taxable bond investments are taxed as ordinary income. One caveat to note with bonds is that treasury bonds, which are those issued and backed by our federal government, are only subject to federal tax, not state and local income taxes.
While we are on the subject of bonds, one of the other few sources of tax-free income is income from what are called municipal bonds, which are basically bonds issued by municipalities such as hospitals or airports. The important caveat to note here is that technically, not all municipal bonds pay tax-free income. There are some taxable municipal bonds, so be aware of what you own. You should also be aware that you will need to be mindful of any potential capital gains generated in these types of non-retirement accounts.
If you sell securities in these accounts at a gain or have mutual funds that pay what are called capital gains distributions, those gains will be subject to capital gains taxes in the years incurred. Capital gains are taxed at the federal level, and the rate depends on whether or not they are short-term or long-term gains.
Short-term gains are taxed as ordinary income, which is not preferred, and long-term gains are taxed at either 0%, 15%, or 20%. High-income earners may also incur a 3.8% surtax in addition. Capital gains vary at the state level, meaning different states treat capital gains differently. Get with your
tax professional on how capital gains apply to you specifically.
You don't need to be a master in taxation to be efficient with your retirement income, but you should be aware of how your own tax situation works. Otherwise, how can you be sure you are being as efficient as possible by keeping more of your own money versus sending the IRS more than you need to?
The job of planning for retirement never ends. Each year, you'll want to check in with your financial advisor or other professional to make sure that your financial strategy is performing as expected and make any adjustments that may be needed to help you stay on track. And as you can see, even those decisions you make in the final months or years leading up to retirement will have a considerable impact. Get them right, and you may be one of those retirees who can honestly proclaim that retirement is all they ever dreamed of and more.
Stay tuned for part two, where I will continue the discussion on important tax aspects of retirement, like tax withholdings, and I will get into healthcare, Medicare, managing your retirement expenses, and last-minute considerations before leaving the workforce.
If you would like to learn more about the rules and strategies discussed in the show and want to find more information to help you retire on your terms, you can find links to the resources we have provided in the show notes, on your podcast app, or you can visit retiredishpodcast.com/4.
You can also sign up for the monthly Retired-ish newsletter there as well, where each month, we discuss money and emotions, investing, tax, estate tips, Medicare and Social Security, and a brief discussion about current markets in layman's terms. We always put something actionable in our newsletters that you can implement right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/4.
If you found this information actionable and insightful, you bet that it can help so many other people, including those closest to you. If you have a moment, please share the podcast with others you personally think could benefit, as it helps us reach more people just like you that need this information.
Thank you for tuning in and following along. See you next time on Retired-ish.
[Fun, Upbeat Rock Music]
# YOU NEED GUIDANCE, STRATEGIES TO USE, YEAH. I’M GONNA SHOW YOU HOW TO DO THIS. INVESTING AND TAX, ESTATE TIPS YOU NEED, YEAH. I'M GONNA GIVE YOU MY HELP. I'M GONNA GIVE YOU MY HELP. OH!
Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take an RMD, a required minimum distribution, in the year you convert, you must do so before converting to a Roth IRA.