Ep #032: The Three Retirement Income Buckets and How They Are Taxed

Introduction

"Hello and welcome back to the podcast, today I am discussing the various income buckets one can have to support their lifestyle in retirement. We’ll dig into each of the three buckets, I will provide examples of the types of accounts and income sources in each as well as how they are taxed."

Business owners depend on their business to fund retirement.

"Now this topic is vital to plan for if you’re a small business owner because over 90% of owners are depending on their business to fund their retirement, while at the same time, less than 20% of businesses actually sell. So this is a huge problem, even if you’re paying yourself a great income of  $200,000 - 300,000 per year, if you are tired, have a health issue, or are just burnt out and want to exit and retire from your business, you will need to sell it or sell a portion of it especially if you are not saving enough outside of your business. Now how to make your business attractive and going about the selling process I discussed on other episodes and won’t dive into that now so let’s assume for today’s topic you are able to sell your business for “x” amount of dollars and that will contribute to your retirement nest egg."

The first retirement income bucket is your non-qualified money.

"Ok so diving right in, the first retirement bucket is your Non-Qualified accounts or non-sheltered accounts. So this is your savings and investments that are non-retirement accounts. This is the bucket where if you sell your business, the net proceeds will fall into. For many business owners who are lucky enough to experience the liquidity event of their business, this bucket tends to be the largest bucket where income will be pulled from."

How non-qualified money (after-tax money) is taxed.

"This is what we call “after-tax money” so there are no penalties in taking it out of your account and you can use as much as you’d like depending on what you need to support yourself and your family. Now these investments can still create some form of taxes because they’ll most likely produce taxable income from interest, dividends, or capital gains. This is why it’s so important to align your investment goals and your income needs with your tax planning so that you avoid getting bumped into the higher tax brackets during retirement. Some ways to help prevent this from happening include using growth stocks that don’t pay dividends rather than income stocks that do pay dividends within your non-qualified investment accounts, using tax-free investments such as municipal bonds, or if you are investing in stocks within your account for more than one year, the dividends are taxed at the more favorable capital gains rates up to 20%."

"Another form of non-sheltered funds for this income bucket would be rental income. It can be a fantastic source of passive income and then eventually when you sell the property, it will produce additional money to go back into your savings and investments within this same bucket."

The second retirement income bucket is social security.

"Bucket 2 is money that would be partly taxable. And the big one in this bucket is social security."

How do you become eligible for social security and when can you start collecting payments?

"The amount you receive varies and is based on your top 40 quarters or 10 years of earnings in your lifetime. When you become eligible for your full benefit is when you reach what’s called Full Retirement Age or FRA. This is typically around age 66-67, depending on when you were born. You can take it earlier starting at age 62 but you will take a 30% cut in income from the normal amount you would otherwise receive if you waited until you reached Full Retirement Age. Now if you wait to begin taking social security payments past your Full Retirement Age your monthly payment would increase by 8% for every year you waited to take it up until age 70. So you want to make sure to start collecting social security at the latest by age 70 because past that there is no benefit to waiting any longer."

How is social security taxed?

"Now something important to know is that your social security is taxable, but only some of it, and only some times. This is where social security can get very complicated but I’ll keep this simple. If your income in retirement is over a certain amount, you would pay tax on 85% of your social security benefits. This is not at an 85% rate. But taxed on 85% of what you receive as an income payment. If your income is a lesser amount, you pay tax on 50% of your monthly benefit. If your income is less than $32,000 per year as a married couple, you do not pay any tax on your social security payments."

"So if you cannot tell already, Social Security can be taken in a variety of ways in planning your income streams for retirement. You can get even more creative when there are two spouses and one can start earlier than the other while the other one can wait. The ultimate goal for anyone is to wait until age 70 to maximize their monthly payment but for many folks, they either can’t wait that long or they don’t want to wait that long. So it all depends on your specific situation."

The third retirement income bucket is tax-sheltered money.

"The third bucket is your tax-sheltered money. These are also known as your Qualified Accounts. So this is your 401k, IRA, or pension. These are what we call sheltered money that is tax-deferred and will be taxable when you take the money out later down the road. It will grow tax-free every year you leave it in your 401k or IRA investment account. This also includes your profit-sharing contributions you can make while you are in business. With this money though, remember at age 73 you must start taking some out to satisfy your Required Minimum Distribution."

"Ok so at a very simplistic level, those are your potential buckets of income that you will pull money from to support your lifestyle."

A quick review of the three retirement income buckets.

"Bucket 1 is your non-sheltered money. This is your Savings and investments that are non-retirement accounts including the net proceeds from selling all or a portion of your business. This bucket also includes rental income."

"Bucket 2 is your partly taxable money mainly consisting of social security payments."

"Bucket 3 is your tax-deferred funds. The 401ks, IRAs, and in some rare cases a pension."

The goal is to be diversified across all three retirement income buckets.

"The goal for you to consider now is making sure you have three buckets to pull income from when it’s time to start your next chapter. You don’t want to have all your money in just a 401k or IRA where there is little liquidity unless you pay taxes and penalties to get your money out. It's the same with having all your money in taxable accounts and not in a sheltered account. You also don’t want all your money in real estate because real estate is illiquid and not easy to sell fast if you fall into difficult times. Having diversification across all 3 buckets will provide you with the most flexibility and income options."

"Overall the main objective to planning for all this well in advance is to make sure you have enough money after taxes to support your lifestyle and ensure you don’t run out of money. Because at the end of the day, we don’t know how long we all are going to live. So getting that roadmap built out much sooner than later will give you more time to get all your accounts in order and make sure you.. are on the right path."