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Income Distribution Planning Goes a Long Way in Funding Retirement

by Howard Hook, CFP®, CPA

As published on, July 9, 2013

Figuring out how much money is needed in retirement is one of the biggest questions facing new retirees. Even after calculating this number, many people have trouble setting up the distributions correctly. Most people assume they will need to replace 100 percent of their pre-retirement salary, which is incorrect.

The four most common sources of retirement income will come from Social Security; a pension; retirement accounts, such as IRAs or 401(k) plans; and non-retirement accounts, such as a brokerage or savings accounts. Because all of these income sources have more favorable tax treatments compared to income from a salary, new retirees need not replace 100 percent of their salary to match their pre-retirement income after taxes.

The most tax-efficient source for retirement funds is found in savings or money market accounts. Distributions from these types of accounts are shielded from taxes. The least tax-efficient sources are distributions from IRAs, 401(k)s and pension incomes, as these distributions are subject to income tax at ordinary income tax rates. They are still more tax-efficient than a salary since salary income is subject to Social Security and Medicare tax, in addition to income tax.

Let's look at an example to see the different distributions needed to replace pre-retirement salary. Bob, age 60, has just retired. His pre-retirement annual income was $80,000 and his take-home pay after income taxes was $56,000. His annual living expenses were equal to his take-home pay. He has an IRA worth $500,000 and a money market account at his local bank worth $200,000. At age 62, he will begin collecting a pension of $2,500 a month and $800 a month in Social Security. He would like to maintain the same lifestyle in retirement that he had while working.

Bob's first thought was to draw money from his IRA account to replace his $80,000 a year salary. If he were to do this, he would need to withdraw $72,000 from the IRA account to net $56,000 after income taxes. This withdrawal represents only 90 percent of his pre-retirement income because his salary was subject to FICA tax of approximately eight percent, to which IRA distributions are not subject.

A better strategy for Bob is to withdraw $56,000 from his money market account to net $56,000 after taxes. The money market withdrawal is just 70 percent of his pre-retirement income since it's not subject to income taxes.

Proper distribution planning is crucial in retirement. The less money that needs to be withdrawn, the less likely it is that a retiree will run out of money. Distribution planning involves understanding the different tax characteristics of each source of retirement income and minimizing the amount needed to be withdrawn from these sources in order to preserve assets throughout retirement.

In closing, it is important to understand that while several sources of retirement income are more tax efficient than salary, individuals should not stop working unless they are comfortable that they will have enough resources in retirement to actually retire. The advantage that working - and continuing to earn income - has over sources of retirement funding is that it delays the need to tap into those retirement income sources or reduces the amount needed from those resources.