How to Design a “Paycheck” for Retirement

For most of our adult lives, the mantra of “work hard, spend less than you earn, and invest” is a message seared into our minds from the days of our first real paychecks. Then for the next 30 or 40 years of our careers, successfully executing this strategy forms a well-worn habit which becomes ingrained in both our day-to-day lives and our psyche. For this and many other reasons, transitioning to a retirement mindset of spending down savings, the polar opposite of this life-long pursuit, can be uncomfortable at best and disconcerting at worst.?

To help smooth out the friction associated with this transition from working to retirement, one technique can be very helpful for a multitude of reasons:? designing a “paycheck” for retirement.?

In its most basic form, the retirement paycheck is nothing more than an automated monthly transfer from the investment portfolio to retirees’ checking account to pay for monthly living expenses. Sounds simple enough. But when breaking down all the moving pieces, this strategy does require some technical knowledge and some legwork. Once established, the “paycheck” can provide a sense of normalcy and peace of mind in what can be a very stressful and uncertain period in one’s life. So, what are some keys to setting this up? As with many financial matters, it’s a mixture of investment, tax, some estimating on the future, and some maintenance to ensure the paycheck amount aligns with the broader picture to maximize the retirees’ chances of a sustainable and enjoyable retirement.

The Basics

As noted above, setting up a monthly paycheck is relatively straightforward. Estimate annual expenses, divide that number by 12 and pick one day a month to set up the automated transfer from the investment account to the checking account. Simple stuff, right? Of course, the devil is in the details as underlying that annual/monthly amount is one of the most critical factors in retirement cash flow planning: the withdrawal rate (annual withdrawal amount divided by portfolio value). Obviously, taking too much out of the portfolio can run the risk of running out of money long before death. Take too little, and the standard of living may suffer. So, there’s a balancing act which requires some work to come up with the initial estimate (the dreaded “budget”) to at least start the monthly transfer.

Of course, it’s always better to start with a conservative amount as it’s easier to increase it versus decreasing. But the good news is that this automated transfer quickly clarifies if the estimate is right or wrong with a monthly “reminder” of having excess funds in the checking account or excess “month” remaining after the amount is spent. If after a year or two, the retiree is constantly transferring extra money from savings to cover standard living expenses, the monthly amount is too low and needs to be moved higher. But this is subject to the amount of assets available and market performance. It’s much more of an art than a science and a critical piece to the analysis is having a trusted method to project how the cash outflows would impact the portfolio over inevitable market cycles.

Cash Management and Portfolio Considerations

After the conservative withdrawal amount is decided upon and in place, retirees should then turn to the required cash management steps. This means allocating the portfolio to ensure the monthly amount is available as liquid cash when the time comes for the automated transfer. Given the potential for volatility in equities (and to a lesser extent, fixed income) a good rule of thumb is to have about six months’ worth of the monthly amount in a money market fund so there’s assurance there’s no volatility on the amount and interest income can still be earned. Then every few months or so, the transfers to the checking account are executed. This necessitates a “rebuilding” of the money market funds to the six-month value. This can be done by selling some fixed income or equities, depending on the asset allocation and market moves.?

Tax Considerations

Along with the cash, another impactful change for retirees is the fact they will no longer have taxes paid via employer withholdings from the traditional paycheck. Without that withholding, retirees need to project the annual tax liability then pay quarterly estimates to keep pace with the IRS’ requirement that tax payments’ timing align with the timing of income. This is where it can be very helpful to coordinate tax and wealth management. Very often, there are many moving pieces to the tax projection (Social Security, capital gains, pension, taxable investment income, charity, other deductions) which necessitate the quarterly estimated payments. If retirees are at the age before RMDs are required, the estimated tax payments are more explicit – meaning they can be done by making a cash transfer from a taxable account.When retirees are taking their RMDs, they can work with their advisor or custodian to withhold estimated federal and state (where applicable) income taxes in a pro-rata amount that approximates the liability for the year. This provides a psychological benefit similar to the traditional paycheck, when the deposit to the checking account was net of taxes, the amount taken from an IRA (RMD) can withhold the proper taxes, assuming the tax projection is accurate.

Bottom Line?

Transitioning to retirement has many moving pieces, including the nuts and bolts of investing, taxes and money movement, and the psychological aspects of no longer getting paid on a regular basis. As we have seen in helping many retirees over the years, “flipping the switch” over to spending down assets instead of saving can be very difficult to digest. But we have found a helpful bridge for this transition for many is the design, execution, and maintenance of the retirement paycheck, which not only provides a helpful guidepost for spending awareness but also the confidence that all those years of delaying gratification can now be cashed in!

Disclaimer:

Johnson Investment Counsel does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.