Ep #044: How to Plan for the Income Distribution Phase of Retirement

Two crucial questions when planning for retirement income

"So you’re thinking about exiting your business. Maybe you’re thinking about retirement or transitioning out of your business to spend more time with family or travel. Two crucial questions have probably crossed your mind. How much do I need to save and where do I need to put it?

Because hopefully, we’re not working for the rest of our lives, even if we enjoy working or don’t consider what we do to be work, many of us hope to one day reach financial freedom, reach financial independence. Which in my opinion simply means not having to worry about money anymore. You have enough money to do what you want, cover your living expenses, and take care of the people you care about. 

In order to reach financial independence we need to think long-term and understand that once we stop working, once we transition out of our business, we’ll need to have an income stream.

Think of it like climbing a mountain. We think the objective is to just get to the top of the mountain. Well, that’s really not the case. Our ultimate goal is to get to the top but then safely make it back down. 

When we think about this in terms of our financial lives, the journey of going up the mountain is the accumulation phase, and getting back down the mountain is the distribution phase. 

Now I’m not a mountain climber but one of the most important things is making sure you’ve brought enough supplies to get you back down the mountain safely. 

Understanding the retirement distribution phase

"In order to do this we need to understand how the retirement distribution phase works so you know where to put your savings in the accumulation phase. The problem is many don’t get the chance to look at their financial situation from the perspective of the distribution phase. Many are generally aware of what they should be doing in the accumulation phase like we should save more, spend less than we make, pay off debt etc. Not being able to look at your financial situation from a distribution perspective can be very costly in the long run because you may discover you’re not saving enough to support yourself and your family in retirement or understand how inflation affects your potential retirement income. Or have the opportunity to project out and look at your future tax situation. Depending on the type of account you take distributions from, some folks can end up paying more taxes in retirement than they were in their working years. 

Pension plans used to take on the responsibility of providing a retirement for people but today, pensions are non-existent and it’s left to the individual to figure out how to participate in a 401k plan. For business owners and entrepreneurs it’s even more difficult, especially if you’re a new business and just trying to survive in the first 5+ years, you’re not saving for retirement. You’re initially pouring all your profit back into the business trying to put food on the table. If you’re lucky enough to become profitable you then need to figure out how to set up a 401k plan or a SEP IRA for your business to save. There’s no employer for the business owner that figured all that out already, it’s up to you to figure it out and put things in place for yourself.

Creating an income stream

"Then once you are contributing to a retirement plan, there’s no information on how putting money into a 401k turns into an income stream for you, later down the road. 

Financial research suggests withdrawing only 4% from your retirement accounts, which if you think about it, you’ll need to save $1,000,000 to live on $40,000 per year in income with that math. Also when you factor in inflation, $100,000 in today’s dollars would be worth $180,000 in 20 years with only 3% inflation. That means in 20 years if you wanted to live off an income of $180,000, you’d need 5m dollars saved up for retirement. How likely is that to happen?

If you’ve been making a high income and have been saving for a long time, you can get there. Or if you’re a business owner, you can build an attractive business and sell it, or if you don’t want to sell your business, if you have a lot of profit there are strategies where you can save hundreds of thousands of dollars a year into a retirement plan.

So there are ways to get there but back to my original point understanding the hurdles of the distribution phase will help ensure you are equipping yourself to make the right financial decisions with your money and your business in the accumulation phase."

How taxes affect your retirement paycheck

"Here are some of the hurdles that you can encounter in the distribution phase and what to look out for:

Taxes: Depending on where you put your money in the accumulation phase, determines how it will be taxed on the back end when you take it as income in the distribution phase. Here’s an example of where to be careful here. If you have $1,000,000 in a 401k or SEP IRA, that’s really not worth $1,000,000. It’s $760,000. Why? Because that money will be taxed at your federal income tax rate and in this example I’m assuming a federal tax rate of 24%. Unless you qualify for an exception when you take it out for income, all this money will eventually be taxed in the distribution phase. And that’s not including state taxes unless you live in one of the nine states where there is no state tax. On top of that in many of the tax-deferred accounts, if you take a distribution before the age of 59.5, the IRS slaps an additional 10% penalty on top of the federal income tax. To understand the types of accounts you are saving into, a 401k and SEP IRA, are tax-deferred accounts. You put money in today, and don’t pay any taxes, but down the road when you take it out, the IRS wants to get paid and you pay the taxes upon distribution.

How a business is taxed on the sale

"Continuing with taxes but from a business owner’s perspective if you are depending on selling your business to fund your retirement. In most cases, your business will be taxed at Long Term Capital Gains rates if you’ve had the business for longer than 1 year. LTC gains rates range from 0, 15, to 20 percent depending on your taxable income. For some context, if you’re married and you end up having a taxable income for the year greater than $554,000 in 2023 you pay 20%. Generally, if you sell a business the vast majority will be paying the top LTC rate of 20%. So if you sell a business for $2,000,000, you’ll net 1.6m in sales proceeds, paying $400,000 in LTCG taxes. And again this isn’t including additional taxes, transaction costs of the sale, or paying your employees, so your net proceeds would most likely be lower than that. In my experience seeing how the sale of your business will play out for your distribution phase will be vital because for many owners the business will make up most of your net worth and you want to make sure you’ll have enough money from the proceeds to fund your desired lifestyle. 

Other potential hurdles in the distribution phase to look out for include, unexpected health expenses, paying for the care of a loved one, someone passing away, becoming disabled, you get sued, all of these can really derail you in the distribution phase if planning wasn’t done in the accumulation phase. 

So what I’d suggest you do and what has worked for me when helping business owners with this is make a list of all your assets with the value of each next to it. Where is the bulk of your net worth? Is it in investment accounts, in real estate, or in your business?

Consider how accessible each asset is. Meaning how fast can you turn that asset into an income stream or be able to access it without penalties and fees? Can that asset eventually be an income stream in the future for you?

What protection is in place for yourself and your business? Do you have appropriate insurance, do you have an asset protection plan, a will, POA, debt repayment plan, or savings strategy, all of these are tools that if you have them in place, can help you get down the mountain, be protected, and provide a sustainable income stream.