The Most Common Sources Of Retirement Income
- Retirement income doesn’t just come from one source. A good retirement plan relies on a diversified portfolio of strategies that will generate income from multiple sources.
- Typical retirement income sources include; Social Security, defined benefit pensions, tax deferred retirement savings accounts, private retirement plans such as IRAs, life insurance and annuities, and non-tax advantaged investments.
- Don’t hesitate to include the idea of working part-time in your retirement plan.
The reality, though, is that you don’t need that much. First off, the calculations are based on $100,000 a year in income, and most retirees can live of much less than that. Second, you will most likely have additional sources of income, some of which I describe below.
You pay into Social Security every paycheck, so you should spend some time getting to understand it’s basics. Social Security can provide a significant supplement to your retirement income. But, you should only think of it as a supplement to your total retirement plan – not your primary source of income. Social Security is a” pay as you go” system. The payroll taxes you pay to the federal government today do not going into a big savings account with your name on it, it’s going directly into the hands of current retirees. As of this writing, 2018, benefits paid were larger than taxes received, so yes, Social Security is running out of money. This does not mean it will disappear, but it does mean Congress may be forced to reduce the benefit it has promised you as some point, most likely as a means test or increase in the minimum retirement age.
Additionally, for most, Social Security benefits are only available after age 67 if you are born after 1960. You may be eligible for benefits sooner if you are born prior to 1960. You can also take benefits at age 62 but for a dramatically reduced amount.
To receive social security benefits, you need work at least 10 years. Benefits are based on your income and are weighted to the lower end, meaning someone making $30,000 a year won’t get a significantly lower amount compared to someone making $50,000 a year. Additionally, benefits are adjusted for inflation, so it’s difficult to give you an estimate of what benefits will be in the future. In the chart below, I have done some quick calculations on benefits assuming a 40-year-old today, 2% annual inflation rate and the chart assumes income never changes.
Tax Deferred Savings Plans
Normally sponsored by your employer, tax deferred retirement savings plans like 401(k)s, SEPs, 457s, and 403(b)s allow you to carve out some of your earnings every month and not pay taxes until you withdraw the money decades in the future. The differences between these plans are just a function of where you work and can be a great deal since you will receive growth on money that is technically the government’s money. You can withdraw and pay taxes after retirement when you will likely be at a lower tax bracket due to reduced income. Additionally, many employers will help you out by matching contributions with their own money, a no brainer if it’s offered to you.
The drawback of deferred retirement savings plans is based on lack of access to the funds. You may think of the money as yours, but any distribution now or after retirement is fully taxable as if it were earned income. Additionally, if you withdraw funds prior to age 59 ½, you will pay an additional 10% penalty tax over and above regular income taxes.
Private Retirement Plans
Whether or not you have access to employer sponsored retirement savings plans, you can always contribute to your own IRA or Roth IRA. These are so important that everyone who has earned income and zero debt should be contributing at least something to either an IRA or Roth IRA every year. You can contribute a combined maximum of $5,500 per year as long as you’ve earned that much, and split that up between IRAs or Roth IRAs.
Like 401(k)s, 403(b)s and other employer sponsored plans, the funds you place into an IRA or Roth IRA are locked into the plans until age 59 ½. You can withdraw them sooner, but you will be subject to potential taxation plus a 10% early withdrawal penalty.
Defined Benefit Pension
Defined benefit pensions are true pensions. Your “benefit” is defined ahead of time. Most other retirement plans are defined contribution plans where there are limits set to how much you can contribute, but no guarantee on what your eventual retirement income will be. Defined benefit pensions typically offer a set retirement income based on the number of years you have worked. For example, if you work for a union for 40 years, they will pay you 40% of your highest 3 years of pay.
Defined benefit pensions are a dying breed, mainly due the cost of offering them. In the past, promises were made that corporations and governments could not keep so availability of pensions have diminished. If you work for a government, government agency or are one of the 6% or so of workers who are in a union, you can probably count on a pension. Otherwise, you are on your own.
Life Insurance and Deferred Annuities
Life insurance companies offer several options to assist savers with planning for retirement. The cash value of whole life and universal life insurance policies can offer significant growth and withdrawals can be completely tax free if policies are structured correctly. The structure of these policies are complex and, quite frankly, there are a lot of bad policies out there, so make sure you are working with a trusted agent who can compare multiple companies.
Deferred annuities can give you tax advantaged growth. More importantly, though, withdrawals from these accounts can be guaranteed to never run out. You could live to 250 and the insurance company will continue paying you your annuity. The guarantee comes at a cost, so make sure, if you are thinking about purchasing an annuity, that you are working with an agent who can help you compare offers from multiple companies, or shop around on your own to get at least 5 quotes from 5 well rated companies before jumping in.
There are tons of things to invest in. Stocks, bonds, savings accounts, real estate, gold, etc. Anything can be a retirement plan. You won’t get the tax benefits of using the plans listed above, but each of the strategies listed have limits on contributions or rules on withdrawals. By utilizing standard, non-tax advantaged investments to fund your retirement, you are giving yourself maximum flexibility in how the money is used in the future. Also keep in mind that the process of turning investments into income vary. For example, how do you turn a gold coin into monthly income? If you believe in using real estate, how confident are you in the consistency of the rental income generated? What happens (as happened to a friend of mine recently) the renters burn the home down and you lose 6 months of rental income while you rebuild?
Just because your goal is retirement, doesn’t mean you should lock all your savings inside retirement plans. There are lot’s of other opportunities out there.
Part Time Work
When consulting with clients about retirement, my favorite suggestion for a source of income is part time work or consulting. I am a strong believer in keeping active in retirement and with unemployment today (2018) at historic lows, there is a significant need for workers in our economy. Working part time may not sound like retirement for a lot of people, but it could play a role if you are not successful at saving the necessary nest egg. I have a friend who retired from the construction industry mainly due his inability to meet the physical demands of the job. His pension and savings are not enough to cover his monthly bills, so he works part time at a golf course. He meets new people every day, stays healthy carrying golf clubs around, and gets to golf free daily at a course he could never afford to frequent otherwise. He loves it and plans to continue working there as long as his health allows.
The Bottom Line
Looking at the savings necessary to retire can be discouraging. Don’t be discouraged though. Every long-term plan has a starting point. The idea is to just get started, stay disciplined, be patient and realize that the best retirement plan is a diversified one where you will be drawing off of multiple sources of income.