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“ The question isn’t at what age I want to retire; it’s at what income. “ -George Foreman
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In the last blog, (See: Almost) Everything About Retirement Funding Sources,) eighteen different funding sources were outlined. That alone would be confusing!
In addition to the sheer number of funding sources, in many cases multiple rules, claiming strategies, and situations exist that alter these basic funding strategies’ effectiveness.
It’s enough to make someone throw up their hands and go back to work! But, let’s see what can be accomplished to simplify all these available choices before you trudge off back to the safety of a secure paycheck.
How to Start Building a Paycheck
I stated in the inaugural blog of Retiring with Enough (See: FOUNDATIONS OF RETIREMENT: THE THREE-LEGGED STOOL) that the goal was to simplify the retirement planning process. So, let’s try to make sense of all the available information, choices, and limitations when trying to fund retirement.
- Step One– The first step in the paycheck-building process will be to review all funding sources outlined in (Almost) Everything About Retirement Funding Sources.
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- Step Two– List all sources of funding personally available. (Your list should include every funding source that you currently have or will have in retirement. Omit funding sources that are not available or relevant. For example, if you don’t have a pension plan, then don’t list it.)
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- Step Three– Separate your funding sources into two categories: guaranteed funding sources and non-guaranteed funding sources.
Guaranteed | Non-guaranteed |
| Pension | |
| Social Security | |
| Government pension/ retirement plan | |
| Annuities | |
| Home equity | |
| Real estate | |
| Side hustle | |
| Inheritance | |
| HSA distributions | |
| Cash value life insurance | |
| Roth accounts | |
| Hobbies | |
| Company sponsored (non pension) retirement accounts | |
| Alimony from divorce | |
| IRA | |
| Brokerage/savings accounts | |
| Part-time work | |
| Small business |
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- Step four– list all guaranteed and non-guaranteed funding sources and monthly anticipated funding amount. This is where the work begins! We’ll take our list and add estimated monthly dollar amounts for each category. (It’s important to understand that this chart will look different for every person or couple based on the types and amounts of guaranteed and non-guaranteed income sources available. The concept is to identify and understand where the income for retirement needs will be derived.)
| Guaranteed | Non-guaranteed | ||
| Pension | IRA | ||
| Social Security | $3,000 | Brokerage/savings accounts | $500 |
| Government pension/ retirement plan | Part-time work | ||
| Annuities | Small business | ||
| Home equity | |||
| Real estate | $500 | ||
| Side hustle | |||
| Inheritance | |||
| HSA distributions | |||
| Cash value life insurance | |||
| Roth accounts | |||
| Hobbies | |||
| Company sponsored (non pension) retirement accounts | |||
| Alimony from divorce | |||
| ____________ | ____________ | ||
| TOTAL | $3,000 | $1,000 |
In the example above there is a guaranteed monthly income of $3,000. If the necessary monthly expenditures have been determined (See: ANNUAL SPENDING- DID I SPEND THAT MUCH ?), then it’s a matter of deducting the guaranteed monthly income from this number. If in our example, the required monthly income is $7,500 then $7,500 minus $3,000 equals a monthly shortfall of $4,500. From the example, there is a monthly non-guaranteed income of $500 from dividend and interest income and $500 from real estate rental income. So, the monthly amount of shortfall is estimated to be $3,500.
| Monthly income needs | -$7,500 |
| Guaranteed monthly payments | $3,000 |
| Non-guaranteed monthly payments | $1,000 |
| ______________ | |
| Monthly income excess or shortfall | -$3,500 |
In this example, after identifying all sources of guaranteed and non-guaranteed income, and plugging the numbers into the equation, it’s been determined that an additional $3,500 will be needed from non-guaranteed sources of income.
So, now the consideration becomes how the additional monthly income needs of $3,500 will be satisfied. This additional $3,500 can come from one or more sources of non-guaranteed income. (Maybe part-time work can generate $1,000 in monthly income. A small business could generate dividends of $500. Stock or bonds can be sold to provide $2,000.) Whatever the sequence and amounts, an additional $3,500 will need to be identified and generated to provide the needed monthly income.
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Let’s look at an example where income exceeds monthly income needs:
| Guaranteed | Non-guaranteed | ||
| Pension | IRA | ||
| Social Security | $3,000 | Brokerage/savings accounts | $1,000 |
| Government pension/ retirement plan | Part-time work | $1,500 | |
| Annuities | $1,500 | Small business | |
| Home equity | |||
| Real estate | $500 | ||
| Side hustle | |||
| Inheritance | |||
| HSA distributions | |||
| Cash value life insurance | |||
| Roth accounts | |||
| Hobbies | |||
| Company sponsored (non pension) retirement accounts | $500 | ||
| Alimony from divorce | |||
| ____________ | ____________ | ||
| TOTAL | $4,500 | $3,500 |
In this example the estimated monthly income equals $8,000.
| Monthly income needs | -$7,500 |
| Guaranteed monthly payments | $4,500 |
| Non-guaranteed monthly payments | $3,500 |
| ______________ | |
| Monthly income excess or shortfall | $500 |
So, instead of a shortfall of $3,500, there is a $500 surplus! The options here would be to increase spending, decrease the income from one or more non-guaranteed sources, or re-invest the difference for additional future income.
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Realistically, the concern for most pre-retirees and retirees will be how to generate monthly income needs from non-guaranteed income.
We’ve identified that many non-income levers can be utilized. But, what are the most tax-efficient and effective options, and what are the best sequences for utilizing these different income sources?
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- Step five– evaluate the non-guaranteed income sources in terms of whether their use will increase taxable income. This is important because this will affect the sequence of use. (Maybe this year you want more or less taxable income. Using different non-guaranteed income sources may or may not increase taxable income depending on how and when they are utilized.)
The following chart indicates whether each non-guaranteed funding source is taxable or non-taxable:
| Taxable | Non-taxable |
| IRA | |
| Brokerage/ savings accounts | Brokerage/savings accounts |
| Part-time work | |
| Small business | |
| Home equity | Home equity |
| Real estate | |
| Side hustle | |
| Inheritance | Inheritance |
| HSA distributions | HSA distributions |
| Cash value life insurance | Cash value life insurance |
| Roth accounts | Roth accounts |
| Hobbies | |
| Company sponsored (non pension) retirement accounts | Company sponsored (non pension) retirement accounts |
| Alimony from divorce | Alimony from divorce |
IRA– one of the great benefits of IRAs is the tax deferral status of contributions and the growth of funds within the IRA. Because the dollars in an IRA are untaxed, as distributions occur the dollars are normally taxed as ordinary income.
Brokerage/ savings accounts– brokerage and savings accounts are tax-efficient and can be considered a blend of taxable and nontaxable components. Principals in brokerage and savings accounts are comprised of after-tax dollars and are free from further taxation, but earnings are normally taxable and are taxed at either ordinary income or capital gain rates, depending on the situation (Principal used to fund lifestyle normally does not cause an increase in taxable income due to its after-tax status.)
Part-time work– earnings from part-time work will be taxed at the ordinary income rate.
Small business– depending on the classification of the small business, income may be considered, ordinary, income, or taxed as capital gains. The same can be said, for the sale of a small business, as how the sale is structured, will dictate how much of the sale is ordinary, income, and how much is considered capital gains.
Home equity– with the sale of a personal home in which you have lived more than two years if you are single, you will pay no capital gains tax on the first $250,000 of profit. (Married couples are allowed a $500,000 exemption.) Any amount of profit over these limits will be taxed, normally as capital gains.
Real estate– non-residential real estate can be taxed in several different manners depending on the situation. Profit generated from the sale of commercial or non-residential real estate is usually considered capital gains, whereas dividends and income are usually taxed differently.
Side hustle– income from a side hustle is normally taxed as ordinary income.
Inheritance– Inherited proceeds may be taxable, but under the present tax code are normally not taxed. Life insurance proceeds or normally non-taxable.
HSA distributions– HSA distributions are tax-free when used to pay qualified medical expenses. Non-qualified distributions may be subject to ordinary income tax rates and a 20% penalty, depending on age, disability status, and date of death.
Cash value life insurance– distribution of the cash value in a life policy normally has both taxable and non-taxable components. Part of the cash value distribution is deemed a return of premiums (basis) and is tax-free, and part is considered earnings and is taxable as ordinary income.
Roth accounts– in almost every case Roth distributions are tax-free ( if they are qualified distributions.) Since contributions are made with after-tax dollars and distribution of these funds is tax-free. Earnings are not taxed or penalized if distributions are qualified.
Hobbies– income derived from hobbies is classified as ordinary income.
Company-sponsored (non-pension) retirement accounts– generally, these accounts are tax-deferred and qualified distributions are taxed as ordinary income. The Secure Act 2.0 has abolished RMDs on Roth 401k accounts ( which generate tax-free distributions) beginning in 2024.
Alimony from divorce– alimony may or may not be taxable. (Divorces finalized after January 1, 2019, abolished taxation of alimony payments.)
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Even with the simplified explanations provided above, it’s easy to see that numerous rules, exceptions, and conditions make navigating funding sources a daunting process. Eight of the fourteen examples above can be either taxable or non-taxable under different conditions. In several cases, the information has changed recently, and information correct today may be incorrect in a short period. Self-education or professional assistance is warranted in most cases.
Future blogs will attempt to “deep dive” into some of the more involved funding sources in an attempt to provide simple and relevant information. Sequencing and tax optimization will also be discussed in future blogs.
Final Thoughts
- Building a retirement paycheck can be a daunting process due to the complexity and variability of funding sources.
- The steps provided in this blog help to simplify the process of generating a retirement paycheck.
- One of the primary steps is to separate funding into guaranteed and non-guaranteed sources of retirement funding.
- The five steps provided separate retirement funding into guaranteed and non-guaranteed sources, and provide information on the tax status of each non-guaranteed funding source.
- This is an important process! This is the money each person or family will use for living expenses after retirement. The retirement spending plan should be carefully and thoughtfully formulated.
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