Thoughts on Retirement Cash Flow

By Alan Silverstein, Fort Collins, Colorado. Email me at ajs@frii.com.
Last update: April 16, 2020

This webpage offers some considerations and suggestions about generating cash flow (spending money) in retirement, at least in the United States. It can be useful for deciding when to retire, and how to optimize resources in retirement.

Note:

• I'm not selling anything and I have no formal financial credentials. This webpage exists to share possibly useful information based on my own reading and experiences.

• This page is fairly short and focused, avoiding temptations to expand in related directions. If something below interests you but you don't know the details, copy/paste keywords into your favorite web search engine to learn a lot more that I won't replicate here.

The Main Question:

"How can I generate cash flow (spending money) during retirement, from my investments and assets, and how much is 'enough'?"

(Couples, substitute "we" for "I", and "our" for "my", throughout this document.)

Note that people measure "wealth" ambiguously as income, assets, or some combination of each. Some high-income people are "rich" despite having a negative net worth, while some zero-income people are "rich" because of having high assets.

Anyway this main question expands into a series of more detailed questions:

1. How much do I need annually to live on, at least today?
2. What sources of perennial income do I have?
3. What's my current net worth?
4. What's the ratio? (annual net spending divided by net worth)
5. How should I tap into my assets?

Plus many footnotes in a separate webpage.

How much do I need annually to live on, at least today?

• How much am I spending now?

  This means dollars leaving your hands, not just shuffling money between accounts or assets. Of course it doesn't include income, only outgo.

  It's good to have a realistic number, but a pain to budget or to track receipts to get that number (unless maybe you're already using something like Quicken anyway). I found a very simple way to do it, which works for me at least; see footnotes.

• How much margin should I leave for rare big expenses?

  Such as: Medical events, new car, major housing repairs, or unusual travel. But at this point focus on just the next few years; that is, adjustments to improve your estimate of short-term cash flow needs.

  But even after you get your retirement cash flow "flying on autopilot," of course be ready to take "manual control" at any time if you have large unexpected expenses or downturns in your portfolio.

• How much margin should I add for income taxes?

  Such as: 10% US federal + 5% Colorado state = 15%. (Might actually be lower overall "effective rate", even if you are in the 10% marginal bracket, but this is a good question to consider.)

What sources of perennial income do I have?

(By "perennial" I mean ongoing indefinitely, perhaps for life.)

These income streams reduce your net cash flow (spending) needs:

• Consider pensions, annuities, and traditional IRA RMDs (1099-R types of accounts, including required minimum distributions starting at 70.5, or later, 72.0), plus Social Security (SSA-1099, kind of like a pension) options, along with when they become available to you.

  Note: Rules and decisions around Social Security are surprisingly complex and worth your time to study, at least when the time comes. For more on this, see footnotes.

• Consider royalties of various kinds (lucky you), rental property income streams, etc (that is, Schedule E types of income).

• Consider trusts, mortgage payments you receive, or other unusual sources of income (1099-MISC).

• Consider taking interest and dividends directly from investments; that is, getting paid directly (such as monthly or quarterly) rather than reinvesting the proceeds into the fund or account (as is often the case).

  For a little more about this option, see footnotes.

Deduct your expected income streams from your annual spending needs. If income exceeds spending and the situation looks stable, game over! You shouldn't have to touch your assets at all, unless you spend more for some reason (either fun or necessity).

However if like most retired people you must dip into your investments to generate cash flow, you can use any perennial income streams to modify (reduce) the ratio described below, from what it would be without the extra income.

What's my current net worth?

• There are many ways to track this, ranging from trivial to impossibly complex. Simpler is better (grin). (Again if you're already using something like Quicken anyway, you might find this easy.)

  For how I do it, see footnotes.

  Should you include the equity in, that is, the net sale value, of your primary home? "You have to live somewhere." It's debatable, you could always downsize, or borrow against the equity.

• What portion of my net worth is pre-tax (still due) versus post-tax? -- Not a critical question at this point, but a good sanity check later when deciding which resources to tap for current cash flow.

What's the ratio? (annual net spending divided by net worth)

• For example: Suppose you find you are actually spending $30K per year, and you bump that up to $40K to allow for taxes and rare big-ticket items, like a new car (remember this is an annual average number) that you haven't bought since you started tracking your actual spending. Also suppose you have no perennial income streams (or have already adjusted your net spending downwards for them), and that your net worth is $1M. (I'm using round numbers, but do it more precisely for yourself.) This means you're currently living (net of new income) on 4%/year of your assets.

• And 4% means that in the simplest analysis your money (savings not including perennial income) should last 25 years, without any additional sources of income. If your ratio is 3%, then you are good for approximately 33 years. (Deciding whether or not to even take a guess at your remaining lifetime, is left as an exercise for the reader.)

• This simple model assumes you can get investment returns at least matching inflation on average: Stocks or bonds, yes; CDs, probably not; real estate, probably, but it's very dependent on where and when, and hard to diversify.

  If your investments don't at least pace inflation, your buying power can shrink greatly over the years. For example, fixed-dollar-amount pensions and annuities effectively lose purchasing power over time.

  If you can beat inflation on average, great. But beware downside risks of aiming for that. Don't gamble what you can't afford to lose -- at least for some years before hopefully the market "corrects." Keep your investments diversified, your costs low, and avoid chasing "hot" sectors. Enough said; you can find a lot more good advice out there about common investing errors and how to avoid them.

  See footnotes for more thoughts on the long-term decrease/increase of your nominal/real net worth.

• This model also assumes you'll have no big changes in your average spending needs. You might want to add in estimated increases due to age-related issues. Or you might want to subtract estimated savings you'll enjoy after you no longer must go to work every day.

  Just don't go crazy trying to predict the future, worrying too much about what I call "the five horsemen of retirement:" Higher costs, lower returns, higher inflation, higher taxes, and/or increased longevity. Build in some margin for unknowns if you like, but remember they are unknowable unknowns. "Whatever happens, I'll be there then to deal with it."

• Yes this is a simplistic model, but it's a great starting point and baseline "touchstone" before adding complicated adjustments, doing Monte Carlo simulations, etc. I found it very useful, as described further in footnotes.

How should I tap into my assets?

First some general thoughts about living off your savings:

• Assuming your annual (perennial) income stream from "income investing", etc, isn't enough to cover your spending needs, which is true for most retired people (or those considering retirement), it's fine to spend down your retirement savings (assets or principal, using "total return investing"). That's what they're for!

• Some people are afraid to retire until their investment spinoffs (like interest, dividends, or rents) are enough to live on, without touching the principal. That can keep you working for a lot more years, maybe for no good reason.

• Your goal is just to avoid outliving your money -- or having to return to work later to earn more. And it helps a lot to draw wisely from your kitty.

• Maybe you should buy an immediate income annuity with some or all of your money, to supplement any Social Security payments? The upside is that most likely a big insurance company will pay you a (somewhat) known amount for as long as you live. The downsides are many, though: Complexity, significant costs, probable loss of buying power to inflation (get an "inflation rider"), risks of massive losses to your estate if you don't live long enough to break even, risk of loss of claims-paying ability of the issuing insurance company, etc.

  I dislike the concept of annuities enough that that's all I'm going to say about them here... In their place, you might consider "managed payout" (endowment-like or time-horizon) funds instead.

• If you care a lot about being generous to relatives or others, perhaps you'll choose to make many gifts while still alive, or aim to leave a significant estate. That's a bonus if you can afford it, but it shouldn't pre-empt your own ability to retire and enjoy life.

• For more philosophizing (at length) about money, saving, investing, and beating inflation, see this separate webpage.

So the fuller question here is: What's the best way to spend down my assets, periodically over the rest of my life, to cover my spending needs remaining after all new income?

(This question is the meat of the matter, and it was my motivation for creating this webpage as I figure out the answer for myself.)

Lots of articles are available online about retirement spending models, such as:

• Fixed-amount (a dollar number increased annually for inflation), versus
• straight-percentage (such as take 4% every year), versus
• hybrids (like take $X/year, but no lower than 3% nor more than 4%).

However you decide each year, "I need $X to spend this year," consider tax efficiency:

• A common, simple narrative is to always defer taxation, such as by first spending your unavoidable taxable income, then withdrawing additional money from your portfolio in this order:
  • Tax-free assets (like savings accounts, maturing CDs, or Roth IRAs when eligible), then
  • partially-taxable (like capital assets with cost bases), especially if the result is preferential income like long-term capital gains (lower tax rates) rather than ordinary income (higher tax rates), then
  • fully-taxable assets (like fully pre-deducted traditional IRAs), especially if they're tax-deferred, leaving them to continue growing.

• But this can be dangerous! For example, what if tax rates or your annual spending increase in the future? You might wish you'd withdrawn from taxable accounts earlier, leaving Roth IRAs in particular to grow longer.

  You might want to withdraw some mix of money from various types of accounts to optimize each year's taxable income (according to your own circumstances). More on that below.

  Bob Adams also suggested: "Avoid triggering other increased taxes or fees such as alternative minimum taxes (AMT), Medicare Part B co-pay, and other similar taxes."

• Consider multi-year income tax leveling, such as:
  • At least enough AGI (adjusted gross income) every year to take advantage of exemptions and standard deductions, meaning "free money" in your pocket with no taxes due -- at least US federal, but also pay attention to state income taxes if applicable.

    This means even if you have sufficient other post-taxed resources, still doing some taxable withdrawals from accounts although you "don't need the money." In fact you might even bump your taxable income beyond the 0% bracket and choose to pay 10% on some income. And you might use the proceeds to buy new investments that rebalance your portfolio.

    See footnotes about differences in categories of income.

  • Whether to use or defer preferential income this year, meaning long-term capital gains (or distributions) and/or qualified dividends.

    For more about this surprisingly tricky topic, see footnotes.

  • Enough pension/annuity income (such as IRA withdrawals/distributions), including perhaps Roth conversions, to take advantage of state exclusions, such as first-$20K in Colorado. (Yes there's added incentive to make Roth conversions! Even if you aren't 59.5 yet, and even if you have no earned income for additional contributions, if you're 55 or over.)

  • Traditional-to-Roth IRA conversions ahead of age 70.5 (or later, age 72.0), if you can afford to pay any related income taxes without using converted funds, to reduce RMD (required minimum distribution) taxation after RMDs start. (Good for both you and your heirs.) Here's a case where paying taxes earlier, instead of deferring them, can save you a lot of money in the long run. (Aiming for multi-year income tax leveling, roughly the same average due annually.) See footnotes for more thoughts about IRA distributions versus conversions.

In addition to tax efficiency, also consider:

• Asset (re)allocations (rebalancing) -- essentially a way to sell winners before losers (and if you don't spend the money now, buy potential future winners), unless you're purposely harvesting capital losses to offset gains. See footnotes for more thoughts on this topic.

• Overall portfolio (resources) available to draw upon, organized by value, type and liquidity, taxability, etc; and portfolio rebalancing effects of liquidating various assets.

  For an example of how I "dashboard" our own resources, see footnotes. Also for thoughts about changes in your net worth over time, see footnotes.

• Asset liquidity versus when cash is needed. In particular, real estate is dicey if you need money in a hurry or must get "top dollar."

  Any money set aside for short-term needs must be safe and liquid, but not necessarily just in a zero-yield checking account, perhaps also some in a short-term bond fund, CDs (but they have withdrawal penalties), etc. Also consider separating "operating funds" from an "emergency account" for unexpected expenses.

• Timing: Keep enough (post-tax) spending money to cover some amount of time (like 6-24 months) in very liquid form (checking, saving, money markets), for flexibility (such as controlling when to liquidate taxable assets) and patience while drawing from other assets. Suze Orman says, "keep it in something you don't have to sell." (Or consider keeping lines of credit open, but use them cautiously.) Some sources refer to these funds as your "short-term spending buckets." See footnotes for more on this topic.

  Some decisions, like Roth conversions, can and should be deferred until late in the tax year when you have a good handle on your expected taxable income for the year. Then you can model the results of additional optional income or conversions before taking action.

  Beyond that I have little to suggest about when or how often you liquidate retirement assets to refill short-term accounts (like checking, savings, or money markets) used for daily expenses. It's a matter of personal preference.

• Black swan events: As mentioned earlier, while it's good to start with knowing how much you're actually spending on average, it's also good to allow for large expenses that are rare month-to-month, but likely over many years. See footnotes for more thoughts on this topic.

• Future income or deductions -- for example if you expect to receive Social Security payments starting in a few years large enough to boost your taxable income, you might accelerate liquidating taxable assets now. Conversely if you expect large enough medical expenses in a few years to take advantage of them in itemized deductions (Schedule A), you might defer cashing in some taxable assets now, waiting until you have offsetting deductions.

• Estate benefits -- leaving capital assets with large gains untouched to pass to heirs tax-free due to the step-up of cost basis upon the owner's death. However if your estate's large enough to trigger estate ("death") taxes, you might accelerate your spending and/or gifting now (up to the annual tax-free limit to each recipient).

• Minimize transaction costs. Unnecessary expenses or "churning" can cut into your net returns a lot, which is an inherent disadvantage for actively-managed mutual funds versus index funds.

• Minimize complexity and stress.

That's it! See footnotes for some links to websites and books on related topics.