Turning savings into retirement income: the moving parts

Retirement reverses the flow of money. A pile of savings and a few benefit programs have to be turned into something that works like a paycheck, for a length of time nobody knows in advance. A retirement income plan is the working document that connects those pieces. This article describes the parts and how they relate to one another.

Start with what the money has to cover

A plan begins with spending. Many people find it useful to sort expenses into two groups.

• Essential expenses: housing, food, utilities, insurance, health care, taxes and transportation.
• Discretionary expenses: travel, hobbies, gifts and other costs that could be reduced or postponed.

The split matters because it shows how much room a household has to adjust. A budget that is almost entirely essential has little flexibility if investments fall. One with a large discretionary share can absorb a poor year by spending less.

Health coverage deserves its own line. Someone who stops working before Medicare eligibility at 65 may buy coverage through the Health Insurance Marketplace, and costs change again once Medicare begins. See health coverage if you retire before 65.

Income that arrives on its own

Some income shows up each month regardless of what markets do.

Social Security. Retirement benefits can begin as early as age 62 or as late as age 70, and the monthly amount is larger the later benefits start. Benefits are generally adjusted each year for increases in the cost of living. See when to claim Social Security.

Pensions and annuities. A traditional pension pays a set monthly amount, often with a choice of survivor options. Some retirees also use part of their savings to buy lifetime income from an insurance company. See annuities: the basic types and how they work.

Work. Part-time earnings in the first years of retirement reduce the amount that has to come from savings.

The gap that savings fill

Subtracting this income from expected spending leaves the amount to be withdrawn from savings each year.

A hypothetical example with round numbers: a couple expects to spend $70,000 a year, of which $50,000 is essential. Social Security and a small pension together provide $45,000. The gap is $25,000 a year, and $5,000 of the essential spending depends on savings. If the couple's steady income were $52,000 instead, every essential bill would be covered before any withdrawal, and the portfolio would be paying only for costs that can be trimmed.

How much a portfolio can provide year after year is uncertain. See the 4% rule and its limits.

Which accounts to draw from

Most retirees hold more than one kind of account, and each is taxed differently.

• Tax-deferred accounts, such as traditional 401(k)s and IRAs. Withdrawals are generally taxed as ordinary income.
• Roth accounts. Qualified withdrawals are generally tax-free.
• Taxable accounts, such as ordinary brokerage and bank accounts. Interest, dividends and realized gains are taxed along the way.

The mix of withdrawals in a given year determines taxable income, which can in turn affect how much of a Social Security benefit is taxed and what a household pays for Medicare. The post on how retirement income is taxed covers this in more detail.

One rule sets a floor. The law generally requires withdrawals from traditional IRAs and most workplace plans to begin at age 73, with a later starting age scheduled for people born in 1960 or later. These required minimum distributions are generally taxable whether or not the money is needed for spending. See RMD basics.

Withholding is part of the plan too. The IRS notes that the taxable part of pension and annuity payments is generally subject to federal income tax withholding, and retirees whose withholding falls short may have to make estimated tax payments during the year.

Risks a plan has to allow for

Several uncertainties run through every retirement plan.

• Longevity. Savings may have to last longer than expected.
• Inflation. Investor.gov explains that inflation reduces purchasing power, which matters for any income that does not rise with prices.
• Market declines. A fall in the portfolio early in retirement can have a larger effect than one later. See sequence-of-returns risk.
• Health and long-term care costs. These can be large and hard to predict.
• The death of a spouse. Household income often falls, since a couple's two Social Security payments generally become one and a pension may shrink or stop, while many costs stay the same.

Common responses include holding a cash reserve for near-term spending, keeping part of the budget flexible, and covering essential costs with income that does not depend on markets. Each has a cost, and no combination removes the uncertainty.

Putting the pieces on one page

A written plan does not have to be elaborate. Many fit on a single page:

1. Annual spending, split into essential and discretionary.
2. Each source of steady income, with its start date and whether it adjusts for inflation.
3. The yearly amount expected from savings, and which accounts it comes from.
4. An estimate of taxes on that income.
5. Where spending money would come from in a year when investments are down.
6. What happens to income if one spouse dies.

Revisiting the plan

The plan made at 62 will not be accurate at 72. Spending shifts, tax rules change, markets move and health changes. Many people review the figures once a year, often when tax documents arrive, and again after any major event such as a move, a death in the family or the start of required distributions.

The purpose of the exercise is less to predict the future than to know in advance which lever to pull when something changes.