Here's how to rebuild your paycheck in retirement.
I usually talk retirement strategy, but today I want to talk tactics. Today is more about how and less about why.
I’m going to show you the steps (and potential pitfalls) when you’re rebuilding your paycheck in retirement. I’m also going to talk about how to build your portfolio so that it can continue to grow, even after you begin taking withdrawals.
You’ve probably spent plenty of time thinking about your retirement account, investments, and maybe even how to reduce your taxes once you have retired. What often gets overlooked is the actual process to turn your savings into income, from your retirement account to your bank account.
Here’s how to save time by automating your investments and your paycheck.
Jeb
Let’s start with the short version
There are three steps to turning your retirement savings into a retirement paycheck.
Make sure you have a base of safer investments in your portfolio. Your portfolio won’t look the same when you’re taking withdrawals as it did when you were still contributing. Things look different when you realize that’s the money, instead of some money. I see it all the time.
Estimate your income for the year, then estimate your marginal tax rate. You’ll use your marginal tax rate to decide how much to withhold for taxes.
Link your bank account to your retirement accounts, add withholding for taxes at your marginal rate, and then set up automatic distributions. This is where you’re actually rebuilding your paycheck. The other steps were just preparation.
When you were working, your paycheck showed up in your bank account every other week or twice a month. You probably didn’t spend much time thinking about it because you knew it would be there.
Your retirement income should be the same. You want to spend your time doing the things you love, not staring at your portfolio.
We all know that the market goes up and it sometimes goes down. You want to build a portfolio that allows you to sleep at night, without worrying about what the market did that day.
The approach I use for my retired clients is incredibly simple. I make sure they have enough safe investments to cover five years worth of withdrawals, then I invest the rest.
The idea here is that you want to have enough in cash and bonds to ride out any market drop without selling your stocks.
If the market pulls back 40%, like in 2008, you don’t want to sell while stocks are down. If you’re selling every month to fund your income, you’d actually be magnifying the effects of the pullback because what you sell can’t keep growing. You’d be locking in your losses.
So how much should you keep in the safe bucket?
I typically recommend at least 25% of your account be in safe investments. That is enough to cover 5 years, withdrawing 5% of the account each year, without considering any growth from interest or dividends.
If you know that you don’t like seeing your portfolio go down, you can always increase the bond portion. The classic retirement portfolio is 60% stocks and 40% bonds, so you can absolutely do that. Just know that by increasing the bond portion of your portfolio, you’re reducing your long-term gains. My old boss used to say for every gimmie, there’s a gotcha, and that applies to investing too.
You might be wondering what I mean by safe investments. There are a few options here that I like, depending on the circumstance. You’ll notice that the increase in interest rates has had a silver lining; many of these options have real yield for the first time in over a decade.
Options
Cash - It’s liquid and you can spend it without any issues. It’s biggest drawback is that it doesn’t pay any interest. I would recommend keeping less than one year of withdrawals in cash at any time, otherwise the cash will lower your returns.
Money Markets - Money markets offer a good combination of liquidity and return. The ones I use are currently yielding over 5%. If you go with a true money market account, it will be FDIC guaranteed, but the rate will likely be lower. If you use a money market fund, which is similar in all but the FDIC protection, you’ll likely get a rate that’s .5%-1% better.
Multi-Year Guaranteed Annuities - A fixed, guaranteed interest rate for a specific term, which provides predictable income and capital preservation. You give up liquidity in exchange for a rate that is guaranteed for longer. Money market funds change their rates often, typically weekly, so while rates are currently high, that can change. MYGA’s offer you the ability to lock a rate for a term, typically from 3 to 10 years. I’ve seen MYGA rates at 6% per year for 5 years, in the last few weeks.
Treasury Bonds - Bonds issued by the US government with terms from three months to thirty years. You lock in the interest rate for the length of the bond when you buy the Treasury. Treasury rates vary from 4.28% for a 30 year bond to 5.49% for a 3 month Treasury, as of the time I’m writing this. If you want to use Treasuries, I recommend building a ladder so that you have some maturing each year. This should keep you from having to sell.
Putting Your Options Together
Your portfolio doesn’t have to be complicated and it doesn’t have to be perfect. There are hundreds of options and combinations you could use, but in reality you only need a couple of the safe investments I mentioned above. Here’s a sample breakdown. (Percentages add up to 25%, because the safe money is 25% of the total portfolio value.)
Option 1
5% Cash + 5% Money Market + 15% Treasury Ladder (5% 1 year Treasury, 5% w year Treasury, 5% 5 year Treasury)
This is super simple and gives you the benefits of diversification and liquidity. It doesn’t even require much upkeep.
After the first year, the 1 year Treasury will mature and turn to cash, replenishing the cash that was withdrawn throughout the year. You’ll also have cash that has accumulated from dividends and interest, which you can then use to buy another Treasury, either 2 or 5 year depending on rates.
Option 2
5% Cash + 20% Multi-Year Guaranteed Annuity
This has less moving parts, but also less liquidity. The MYGA will have rates a bit higher than Treasuries or money market funds, but the tradeoff is that most of your money is locked in for at least three years.
With this option, all you do is move 5% from the MYGA to cash each year. You can do that in a few minutes and you only have to do it once. It couldn’t be simpler.
Bottom Line
Don’t overthink this. It doesn’t have to be complicated or take hours each week. Ideally, you set it and forget it. Even if you do enjoy focusing on your investments, your safe money isn’t where you should be spending your time.
Turning portfolio income into a paycheck
When you were working, you received your paycheck every other week or maybe on the 1st and the 15th. Retirement is going to be a bit different.
Most retirees receive multiple paychecks each month. Retirees often receive income from pensions and Social Security, in addition to any withdrawals they’re making.
Honestly, this isn’t a big deal. You just have to consider two items.
Timing the cashflow
Withholding the right amount
Timing
The timing is simple. You just have to make sure you have cash in your checking account when it’s time to pay your bills. It doesn’t matter how much income you have coming in, if it doesn’t arrive till after your bill is due.
You can only control so much here. Pensions pay on the same date each month, but you usually can’t control that date. Social Security pays based on the date you were born. Weird, I know.
Birth Day 1st – 10th 11th – 20th 21st – 31st | Pay Day Second Wednesday of the month Third Wednesday of the month Fourth Wednesday of the month |
That leaves you with your withdrawals. Many retirees default to taking their monthly withdrawal on the 1st of the month, but you can set it to any date. I recommend looking at your expenses and seeing if it would be advantageous to move it to a different time.
Tax Withholdings
Tax withholdings while can be confusing, especially when you have a family and you’re dialing in the right number of exemptions. Luckily, they’re simpler in retirement. You typically withhold a percentage for federal taxes and a percentage for state taxes. That’s it.
The key here is to make sure you’re withholding enough. If you overpay, it’s annoying but you’ll get it back when you file your taxes. If you underpay, it can be a hassle because paying the extra will impact your cash flow.
Let’s talk how much to withhold.
Pull up an income tax calculator online. You can do this by hand but honestly, it’s not necessary. It’s simpler to just type in the numbers and get the result.
From this, you’ll have an idea of your marginal tax rate and your average tax rate. You’ll also know if your Social Security will be taxed and if so, how much.
From there, set the withholdings on both your retirement account withdrawals and your Social Security at your marginal tax rate. You’ll likely overpay by a bit, but you won’t have to worry about underpaying or figuring out your exact tax estimate.
Linking Bank Accounts
You were likely paid via direct deposit when you were working. You’ll want the same once you retire. The easiest way to do this is by linking your bank account to your retirement accounts.
If you have an advisor, they should do this for you. If you don’t, most custodians like Schwab, Fidelity, and Vanguard make the process simple. Many use a service called Plaid to verify your bank account. You can input your tax withholdings once you set up your bank link.
Make sure that you only set up withholdings for your Traditional IRA or 401(k). Roth accounts are taxable and taxable brokerage accounts don’t allow for withholdings.
Once you have the bank link and withholdings set up, you can add the monthly payments that we discussed earlier.
You have now recreated your paycheck via direct deposit, with money withheld for taxes. Go enjoy retirement.
-Jeb
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