There are 6 additional strategies to generate extra income in retirement and extend the life of your savings.
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Buy an Annuity
Unless you’re a retired public service employee or you worked for one of the handfuls of companies that still offer a traditional pension, you’re not going to receive a monthly paycheck from your employer for the rest of your life. But that doesn’t mean that a guaranteed source of lifetime income in retirement is an impossible dream. You can create your own pension by buying an immediate fixed annuity.
When you buy an immediate annuity, you give an insurance company a lump sum in exchange for a monthly check, usually for life. You can buy an annuity that has survivor benefits so that it will continue to pay your spouse after you die. But you pay for that protection by accepting smaller monthly payouts. Another option is a deferred-income annuity; you purchase the annuity when you’re in your fifties or sixties, but the payments don’t start for at least 10 years. The longer you wait, the bigger the payouts. Of course, if you die before payments start, you get nothing–unless you opt for a return of premium or survivor benefits. Copyright © 2017 The Kiplinger Washington Editors. All rights reserved. Distributed by Financial Media Exchange. (These products are often referred to as longevity insurance because they protect you from the risk of outliving your savings.)
A relatively new type of deferred-income annuity, a qualified longevity annuity contract (QLAC), offers a tax benefit for retirees who have a lot of money in tax-deferred retirement accounts. You can invest up to 25% of your traditional IRA or 401(k) plan (or $125,000, whichever is less) in a QLAC without taking the required minimum distributions on that money when you turn 70½. To qualify for this special tax treatment, your payments must begin no later than age 85.
An analysis by New York Life illustrates how this strategy could lower your tax bill. A 70-year-old retiree in the 28% tax bracket with $500,000 in an IRA would pay about $117,000 in taxes on RMDs between age 70 and 85, assuming 5% annual net returns. If the retiree opted instead to put 25% of the IRA balance into a QLAC at age 70, he would pay roughly $87,000 in taxes over the same period–a $30,000 reduction. Taxes would increase, however, once the annuity payments began at 85.
TIP: Don’t stash all of your nest eggs in an annuity. Most experts recommend investing no more than 25% to 40% of your savings in an annuity. Alternatively, calculate your basic expenses, such as your mortgage, property taxes, and utilities, and buy an annuity that, when added to Social Security benefits, will cover those costs.
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Minimize Taxes
To get the most out of your income in retirement, you need to shield as much as possible from Uncle Sam. Fortunately, there are plenty of legal ways to lower your tax bill, but they require careful planning and a thorough understanding of how your different retirement accounts are taxed.
Let’s start with your taxable brokerage accounts– money you haven’t invested in an IRA or other tax-deferred account. Because you’ve already paid taxes on that money, you’ll be taxed only on interest and dividends as they’re earned and capital gains when you sell an asset. The top long-term capital gains rate–which applies to assets held for more than a year–is 23.8%, but most taxpayers pay 15%. The rate is 0% for taxpayers in the 10% or 15% bracket. For 2017, a married couple with an income of $75,900 or less can qualify for this sweet deal.
Next up: your tax-deferred accounts, such as your IRAs and 401(k) plans. Withdrawals from these accounts are taxed at ordinary income rates, which range from 10% to 39.6%. The accounts grow tax-deferred until you take withdrawals, but you can’t wait forever. Once you turn 70½, you’ll have to take required minimum distributions (RMDs) every year, based on the year-end balance of all of your tax-deferred accounts, divided by a life-expectancy factor provided by the IRS that’s based on your age. The only exception to this rule applies if you are still working at 70½ and have a 401(k) plan with your current employer; in that case, you don’t have to take RMDs from that account. You’ll still have to take withdrawals from your other 401(k) plans and traditional IRAs unless your employer allows you to roll them into your 401(k).
Finally, there are Roth IRAs, and the rules for them are refreshingly straightforward: All withdrawals are tax-free, as long as you’ve owned the account for at least five years (you can withdraw contributions tax-free at any time). There are no required distributions, so if you don’t need the money, you can leave it in the account to grow for your heirs. This flexibility makes the Roth an invaluable apparatus in your retirement toolkit. If you need money for a major expense, you can take a large withdrawal without triggering a tax bill. And if you don’t need the money, the account will continue to grow, unencumbered by taxes.
Conventional wisdom holds that you should tap your taxable accounts first, particularly if your income is low enough to qualify for tax-free capital gains. Next, take withdrawals from your tax-deferred accounts, followed by your tax-free Roth accounts so you can take advantage of tax-deferred and tax-free growth.
There are some exceptions to this hierarchy. If you have a large amount of money in traditional IRAs and 401(k) plans, your RMDs could push you into Copyright © 2017 The Kiplinger Washington Editors. All rights reserved. Distributed by Financial Media Exchange. a higher tax bracket. To avoid that scenario, consider taking withdrawals from your tax-deferred accounts before you turn 70½. Work with a financial planner or tax professional to ensure that the amount you withdraw won’t propel you into a higher tax bracket or trigger other taxes tied to your adjusted gross income, such as taxes on your Social Security benefits. The withdrawals will shrink the size of your tax-deferred accounts, thus reducing the amount you’ll be required to take out when you turn 70½.
Another strategy to reduce taxes on your IRAs and 401(k) plans is to convert some of that money to a Roth. One downside: The conversion will be taxed as ordinary income and could bump you into a higher tax bracket. To avoid bracket creep, roll a portion of your IRA into a Roth every year, with an eye toward how the transaction will affect your taxable income.
TIP: If the stock market takes a dive, you may be able to reduce the cost of converting to a Roth. Your tax bill is based on the fair market value of the assets at the time of the conversion, so a depressed portfolio will leave you with a lower tax bill. If your investments rebound after the conversion, those gains, now protected inside a Roth, will be tax-free. Should the value of your assets continue to plummet after you convert, there’s a safety valve: You have until the following year’s tax-filing extension (typically October 15) to undo the conversion and eliminate the tax bill. If prospects for major tax reform and rate cuts come to fruition, it could open a golden era for Roth conversions. Keep an eye on Congress.
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Manage Your Pension
At a time when defined-benefit plans are becoming as rare as typewriters, consider yourself fortunate if you have a traditional pension to manage. Even so, the decisions you make about how you take your pension payout could have a significant impact on the amount of income you receive.
One of the first decisions you’ll probably have to make is whether to take your pension as a lump sum or as a lifetime payout. A lump sum could make sense if you have other assets, such as life insurance or a sizable investment portfolio, and if you’re comfortable managing your money (or paying someone else to do it for you). You’ll also have more flexibility to take withdrawals, and your investments could grow faster than the rate of inflation. What you don’t spend will go to your heirs.
A lifetime payout, however, offers protection against market downturns, and you won’t have to worry about outliving your money. You’ll probably also get a higher payout from your former employer than you could get by taking a lump sum and buying an annuity from an insurer.
Consider longevity when deciding how to structure your lifetime payout. Married couples have a couple of basic options for their payments: single life or joint and survivor. Taking the single-life payment will deliver bigger monthly payments, but your pension will end when you die. By law, if you’re married, you must obtain your spouse’s consent before taking this option. With the joint-and-survivor alternative, payments will be smaller, but they’ll continue as long as you or your spouse is alive.
The survivor benefit is based on the pension participant’s benefit. Plans must offer a 50% option, which pays the survivor 50% of the joint benefit. Other survivor-benefit options range from 66% to 100% of the joint benefit. In most cases, the benefit drops no matter who dies first, unless you choose the 100% option.
TIP: In general, women who want lifetime income should take the pension’s monthly payout. Pension plans use gender-neutral calculations, which can further complicate the choice of monthly payments versus a lump sum. Because women tend to live longer than men, it’s highly likely that the pension plan will offer a higher payout than they could get on the open market. For example, a 65-year-old man who wants to buy an annuity that will provide $60,000 a year for life would need about $914,000, according to Immediateannuities.com. A 65-year-old woman would need about $955,000–roughly $40,000 more–to get the same amount of annual income. If you take the pension, however, your payment is Copyright © 2017 The Kiplinger Washington Editors. All rights reserved. Distributed by Financial Media Exchange. based on your years of service and salary; your gender doesn’t play a role.
When it comes to converting the pension payment to a lump sum, however, gender neutrality can work against women. If their longer life expectancy could be taken into account, the lump sum would have to be larger to equate to the higher lifetime costs of the monthly payments.
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Tap Permanent Life Insurance
Most of us buy life insurance to provide financial security for our loved ones after we’re gone, but a permanent life insurance policy could provide a valuable source of income while you’re still around to enjoy it.
A permanent life insurance policy has two components: the death benefit, which is the amount that will be paid to your beneficiaries when you die, and the cash value, tax-advantaged savings account that’s funded by a portion of your premiums. With whole life and universal life, the insurance company usually promises that a minimal level of interest, after insurance costs and expenses are deducted, will be credited to your account every year. With variable life insurance policies, you choose the investments and may not get a guarantee.
You can withdraw your basis–the amount in the cash-value account you’ve paid in premiums–tax-free. That could provide a cash cushion in case, say, the stock market takes a 2008-style downturn and you want to give your portfolio a chance to recover. (Withdrawals that exceed what’s in the cash-value account will be taxed in your top tax bracket.) The death benefit will be reduced by the total amount you withdraw. You can also borrow against your policy, and you won’t have to undergo a credit check. Interest rates range from 5% to 8%, depending on market rates and whether the loan is fixed or variable. If you don’t repay the loan, or pay back only part of it, the balance will be deducted from your death benefit when you die.
When you borrow against your policy, you’re not taking withdrawals from your account that you’ll pay back later, as is the case with a 401(k) loan. Rather, the insurer is lending you money and using your policy as collateral. Unless you pay the interest out of pocket, it will be added to the loan balance. If the balance exceeds the policy’s cash value, the policy could lapse, and you’ll owe taxes on the amount of the cash value, including loans, that exceed the premiums you paid.
What if you need a regular source of income? One option is to convert your life insurance into an income annuity through what’s known as a 1035 exchange. The downside to this strategy is that you’ll give up the death benefit, but you’ll lock in income for the rest of your life, or for a specific number of years. The conversion is tax-free, but you’ll pay taxes on a portion of each payout, based on the proportion of your basis to your gains. Your insurance company may offer an income annuity, but you should look at payouts offered by other providers, too. Go to www.immediateannuities.com to comparison shop.
TIP: If your insurance policy pays dividends, you can generate income without giving up the death benefit. Instead of reinvesting the dividends in the policy, which will increase its death benefit and cash value, you can take the dividends in cash. Dividends typically range from 5% to 6.7%, and any dividends you receive up to the policy’s cost basis are tax-free. Dividends that exceed that amount are taxable.
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Plan for Health Care Costs
Fidelity Investments estimates that the average 65- year-old couple retiring now will need about $260,000 to pay out-of-pocket health care costs, including deductibles and Medicare premiums, over the rest of their lives. That doesn’t include long-term care, which can be a major budget buster.
There are a variety of options to help pay these future medical bills. One tax-friendly way is a health savings account. As long as you have an eligible high-deductible health insurance policy, you can contribute to an HSA either through your employer or on your own (but you can no longer contribute after you’ve signed up for Medicare). Copyright © 2017 The Kiplinger Washington Editors. All rights reserved. Distributed by Financial Media Exchange. An HSA offers a triple tax advantage. You contribute money on a pretax basis to the account. Money in the account grows tax-deferred. And withdrawals are tax-free if used to pay medical expenses, either today or when you’re retired. (You’ll owe income taxes and a 20% penalty on withdrawals used for other purposes, although the penalty disappears once you turn 65.)
To make the most of the HSA, contribute as much as you can to the account and pay current medical bills out of pocket. That way, the money in the account has time to grow. Years from now, you can use HSA funds to reimburse yourself for medical bills you’re paying today. The maximum contribution for 2017 is $3,400 for single coverage and $6,750 for families, plus an extra $1,000 if you’re 55 or older. Your health insurance policy must have a deductible of at least $1,300 for singles and $2,600 for families.
Employers are increasingly offering workers this option to contain costs because premiums for high deductible plans tend to be lower than for traditional insurance. Among Fidelity-run plans, nine out of 10 employers kick in money to workers’ accounts to encourage participation, says Eric Dowley, senior vice president of Fidelity’s HSA product management. The average employer contribution is $541 for singles and $991 for families.
If you’re looking for an HSA on your own, review fees and investment options. Morningstar recently looked at plans offered by the 10 most prominent providers and found that only one–offered by The HSA Authority–did a good job for both current spending and future investing.
You can use HSA funds to pay for long-term-care premiums–but that’s a small compensation given the steep price tag for a long-term-care policy. If you can’t afford a long-term-care policy that would cover at least three years of long-term care with inflation protection, another option is to buy enough coverage to pay the difference between the cost of care for three years and what you can afford to pay from savings and income.
Another solution is a hybrid policy that combines life insurance and long-term-care benefits. It’s basically a permanent life insurance policy that allows you to spend down the death benefit to pay for long-term care should you need it. You can also get a rider that will cover long-term care above and beyond the death benefit. If you don’t need long-term care or don’t entirely use up the death benefit, your heirs will collect what remains of it.
One company, for example, offers a hybrid policy that you purchase with an up-front lump sum or in installments over 10 years. A 60-year-old man paying $10,000 a year over a decade could get monthly long-term-care benefits at age 80 of $7,983 for up to six years, growing at 3% annually. The death benefit at that point would total $106,400, or he could cash in the policy and get 80% of his premiums returned. Under a similar scenario, a woman would get $7,076 per month for long-term care or a $113,600 death benefit.
The trade-off is that hybrid policies are doing double duty, so you’ll get a lower long-term-care benefit for your money than if you purchased a stand-alone long-term-care policy, says Bill Dyess, president of Dyess Insurance Services, in Boca Raton, Fla.
TIP: If paying for long-term care is your chief goal and you don’t need more life insurance, buy a stand-alone policy rather than a hybrid policy. Today’s long-term-care policies are more accurately priced than those issued years ago, so it’s less likely that you’ll see steep premium jumps in the future, says Pinnacle’s Kitces. Plus, you may be able to deduct part of your premiums on your tax return, something you generally can’t do with a hybrid policy.
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Move to a Cheaper Locale
Downsizing to a smaller place, particularly after the kids are launched, is a common way to lower housing costs and stay close to family. If you live in a highly appreciated home, selling can free up large sums that can be used to wipe out debt, add to a nest egg or pay future long-term-care costs. (Married couples can protect up to $500,000 in Copyright © 2017 The Kiplinger Washington Editors. All rights reserved. Distributed by Financial Media Exchange. profit from the sale of a house from capital gains tax; singles can shelter half that amount.)
But for a move to become a financial game changer and significantly lower living costs, consider putting down roots in a state where housing and living expenses are cheaper. “This can take a retirement situation that is nearly hopeless and turn it into one that is comfortable,” says Tim Maurer, director of personal finance for BAMAlliance in Charleston, S.C. For example, housing costs in San Diego are 173% higher than in Galveston, Texas, according to Bestplaces.net. Galveston made Kiplinger’s most recent list of great places to retire. Kiplinger also compiles a list of the most tax-friendly states for retirees. Moving to a state that gives retirees a big tax break can free up money for a higher standard of living in retirement.
Kevin McGrain, 62, was able to retire last year as an executive of a catalog company after he moved from the Northeast to the Sun Belt. Two years ago, McGrain and his wife, Linda, traded in a $700,000 four-bedroom house on a small lot in Newburyport, Mass., for a $400,000 four-bedroom home in Inman, S.C., that sits on an acre of lakefront property with a view of the Blue Ridge Mountains. He says he doesn’t think he could have retired when he did if he hadn’t moved to South Carolina.
In Massachusetts, the McGrains’ property taxes were $15,000 a year, and monthly utility bills some winters reached $600. In South Carolina, the couple’s property taxes run $1,700 a year, and at age 65 they’ll be eligible for a special exemption that will reduce that bill even further. Their utility bills now average $150 a month.
Better yet, McGrain, who is an avid golfer, says his country-club fees are half of what they used to be, and he can play 11 months out of the year instead of seven.
TIP: Before moving to a new zip code, do some field research. Take an extended vacation to experience day-to-day living in the new neighborhood you’re considering (you may be able to rent a place via Airbnb or VRBO). Visit in the offseason to see if the weather agrees with you. And meet up with a local real estate agent for a lowdown on the area.
