Retirement Distribution methods

At the time of retirement, you may be making some of the most important financial decisions of your life. Choosing how you take your pension, when you take Social Security and how much you will spend each year lifetime consequences. Also, once you do retire, you have many pots of money to use. Careful planning can save you a lot in taxes by maximizing your income while keeping your taxes low.

Social Security and pension money

Most of us will have monthly checks from Social Security, pension plans and possibly other sources. At the very least, your Social Security check is adjusted for inflation. Your pension may also be inflation adjusted. Later we will discuss the best timing and distribution methods for these sources of income.

Retirement savings accounts

Next you have your retirement savings accounts. 401k's, SEP's and Traditional IRA's are 100% taxable when you withdraw money. It is impossible to predict future tax rates, but looking at different scenarios will help determine the best distribution strategy for you.

• It could be to your benefit to add up these accounts and start taking equal installments from the total amount throughout your and your partner's combined retirement period. This prevents having to take huge chunks after you are 70 1/2 and spreads out your tax burden.

• There are mitigating circumstances about taking installments from your retirement savings accounts if one of you is still earning income. Adding IRA distribution money to your earnings may subject you to much higher taxes.

• Also, you have to weigh the benefits of having your money grow tax deferred for as long as possible vs. paying ordinary income tax sooner and letting the money grow outside of a retirement account to be taxed again by a possibly lower capital gains rate if you don't need the money right away.

• Finally, your distribution method depends on factors like having enough income from other sources or wishing to leave a big inheritance. If you have few other sources it is important that you do not take out too much and run the risk of running out of money.

Add monthly income from Social Security, pension and taxable retirement savings accounts up. Does this amount equal your monthly income need? If so, you can stop here. If not, look at distributions from your Roth IRA and other accounts.

Roth IRA's

If you have a Roth IRA, this money is available without tax consequences. Use this money to top off distributions to meet your income needs. Doing so will keep your tax bracket lower than if you took more from your taxable retirement savings accounts.

Consider converting your regular IRA to a Roth IRA. This works best if you will not need the income from the Roth IRA. Income limits apply and taxes are payable at the time of conversion. No minimum distributions at 70 ½ are required and your heirs will get tax free income for the rest of their lives.

Other investments

Finally, you have all other investments. Using each of these investments results in some tax consequence (unless one is selling a primary residence with less than the exempted gain). If your retirement planning includes selling investment real estate or cashing in on your business, see a professional such as a planner or an accountant to maximize this segment of planning. Use these investments wisely by considering the tax cost of using each investment.

Choosing a pension distribution method

If you have a pension in your current job, go to see your Human Resources representative years before you plan to retire. Understanding the mechanics of your pension may be one of the most important financial actions you can take.

When you do take your pension, you will have several options about how you take it. Usually pensions offer the following:

Lump Sum

Taking the accrued value of your pension in one lump sum may or may not be a good idea. You can take the value and roll it into an IRA, giving you a greater choice of investments and optimizing potential growth of your pension money. Additionally, if you take a lump sum, you avoid the possibility that if you die early on in retirement your payments will stop, leaving nothing for your heirs. (Note : Leaving money in a pension will better shelter the money from creditors than rolling it over to an IRA which only has limited protection from creditors.)

If your pension plan has inflation protection, taking a lump sum is like leaving a bird in the hand for two in the bush. Managing your own pension means you feel you can get more return than inflation plus pension earnings, (a higher real rate of return). Consider this option carefully.

Life only

This is usually the highest payout (outside of a lump sum) and means you will get the pension only as long as you live. It will stop when you die. There will be no inheritance from this money. This may be a viable option if you have no spouse or heirs to consider or if you are in a relationship where you are much younger than your spouse and/ or if you have plenty of whole life or adjustable life insurance. You may be able to insure your spouse for less money per year than you give up for choosing a distribution choice that goes on after you die.

Survivorship options

At retirement, married pension plan participants can choose to take a reduced pension for the lifetime of both themselves and their spouse. This can be a costly option if the spouse lives a short time and the retiree is left with a lifetime of reduced payments, or if both husband and wife die within a few years of each other.

In some cases, this may be the best option such as if your spouse handles money poorly and you want to have him or her have a steady income, or if your spouse is much younger. Do the math to calculate the expense vs. potential rewards of taking this option.

When do you take social security?

Social Security reform is the hot issue in Washington. What Social Security will look like when you need it is up in the air.

Using today's rules, generally, it's best to take Social Security once you've stopped earning other income and have reached the full eligibility age. If you have stopped working and/or are in poor health, personal circumstances may favor you taking Social Security at the youngest available age.

Enrolling in Medicare.

Current law gives you an opportunity to sign up for Medicare Part A and B when you take Social Security or when you reach Social Security's normal retirement age.

Additionally, you can choose to enroll in Medi-Gap coverage to cover services more than A and B cover. Check with a health insurance agent to help you make the decision about when to apply and what kind of coverage fits you best.

Getting long-term care insurance

Seriously consider purchasing long-term care insurance if you haven't already. Long-term care expenses can ruin any retirement and/or inheritance plan unless you have substantial wealth. As a member of a couple, consider the financial effects of substantial health costs on your partner and your family as well as yourself.

Although some companies sell policies for people in their late 70s or early 80's, health issues can prevent you from getting insurance then. We recommend that you buy it while you are relatively young and healthy, pay an affordable premium, and hope that it's the worst investment you ever made. See the section of insurance for more detailed information.

Mortgage management

When your earnings decrease, that tax benefit of deduction mortgage interest decreases too.

Consider your personal circumstances:

      If you have a large mortgage balance and an adjustable mortgage, think about whether it makes sense to refinance into a 30 year fixed if cash-flow is a major concern. You will at least have a known cost. Remember, however, every time you refinance you pay costs and you are increasing the term of your loan. The payment may be lower, but you will owe money to the bank longer.

      If you have a large loan balance and the good cash flow, refinance to a 15 year fixed mortgage, or substantially increase your payments to pay down the balance on your existing loan.

By making extra larger monthly payments, you will be earning the equivalent of your mortgage rate (minus your average tax rate) in benefits. (If your mortgage is 7%, you will be saving 7% (minus your average tax rate) every month in avoided interest payments for the term of your loan on extra money you add to your payments. (Can you get that rate of return risk-free elsewhere?) If you pay an extra $100 per month on a $500,000 thirty year loan at 7%, you save $75,168 in interest.

      If you have a smaller mortgage balance, consider paying it off completely or increasing your payments.

When you retire you have a finite pot of money. Paying interest of any kind eats away at your money. All things being equal, paying off your mortgage five years early saves you five years of interest. This may not be a good idea if you have to take taxable income such as an IRA to pay it off, or if you may move. See us to analyze your personal situation.

Seek professional help before engaging in any of the tax savings techniques mentioned above.

Kerstin Eriksson-Splawn, EA, CFP® and Barbara Bachelder, CFP® for Wealth by Design, LLC