Retirement is one of the most crucial phases of your life, and it is essential to plan and prepare for it. The right decisions can allow you to live comfortably and enjoy a financially secure retirement. On the other hand, the wrong choices may make you feel like you're living from one pension check to the next if you lucky enough to have that.
The Decumulation Phase of Retirement is unique because it requires careful budgeting, smart decisions, and sound financial management skills. In this post, we'll discuss the Decumulation Phase of Retirement and how it could affect your budget.
Decumulation Phase vs the Accumulation Phase
An accumulation phase consists of strategies used by investors to grow assets over an extended period, it’s a time to save and invest effectively. The decumulation phase of retirement is when you no longer work and draw down your retirement accounts that you worked so hard to grow. It can be a confusing period for many. Practically, this requires finding ways to utilize retirement assets in a way that ensures they last as long as you live.
During the decumulation phase a common concern for many retirees is how to pay the bills once they stop working. Four primary sources can generate income in retirement. The common contributor to all these income groups is Social Security. Labor, capital, and pensions will provide additional income on top of Social Security for those who have them.
That said, you should consider how you plan on drawing down your balances (decumulation phase) post-retirement when you are creating your retirement savings strategy. This is especially for future retirees.
Based on analyses
From the 1990s to 2000s, there were many tailwinds for retirees and those planning for retirement, thereby reducing the need to draw down into retirement savings principal for a comfortable living standard.
Future retirees might not have such a fortunate retirement. They may face multiple headwinds when they retire. This equates to a need to save even more and increase their overall savings. Several significant challenges are ahead; from increased taxes, potential for high inflation, reduced returns on investment forecasts, and cuts to Social Security benefits.
Tax and insurance cost considerations
One of the primary considerations that should be made during the decumulation phase is Medicare insurance. IRMAA (Income-Related Monthly Adjustment Amount) adjusts the monthly premium cost associated with Medicare Part B and D. This cost is based on Medicare tax brackets that stem from MAGI (Modified Adjusted Gross Income) as determined by the government. In some cases, if your income rises higher by a dollar above a specific tax bracket during decumulation, you could be forced to pay thousands more in Medicare premiums in the years that follow.
Income taxes are another important consideration when drawing down your retirement accounts. You should understand what taxes will be due on various withdrawals and what tax-saving strategies may be available to you. For instance, if you have a Roth IRA, any withdrawals from that are not taxable. However, as you draw from various accounts you should be aware it could place you into a higher tax bracket at which point any income above and beyond that will be subject to increased tax.
Let's say you have an income of $40,000 per year. At that point, you're in the 12% marginal tax bracket. Many people don't realize that if you were to make more than $40,525, you would be subject to 22% tax on any income earned or drawn from applicable accounts. This tax due can quickly eat away at your overall balance if not managed properly, so it's essential to understand these rates and what they mean!
Another concern is the Social Security Tax Torpedo. Social Security is not taxable for individuals with provisional income under $25,000 ($32,000 for couples). Social Security earnings are only taxable in ranges where provisional income reaches between $25,001-$34,000 ($32,001-44,000 for couples). If you not managing your tax brackets and income streams effectively your Social Security can be subject to a compounding tax rate.
It would be advised to inquire with a financial professional to get a better understanding of how the Social Security Tax Torpedo can effect you and how to avoid it.
What are some tips for managing your budget during the decumulation phase?
When one enters retirement, it is advisable to withdraw from the least flexible and least tax-efficient account(s) first to maximize their ability to defer taxes. Withdraw from your taxable accounts (TDAs ) first and save your tax-exempt accounts for later.
Another tip is to create a basic financial plan to figure out if you have plenty of money to fund your retirement income in your estimated lifespan. Make sure to look at whether or not all of your assets are being allocated efficiently, as each account has its own purpose! If the numbers don't add up, consider directing surplus to practical uses (such as investing in a business).
Tax-exempt life insurance or Annuity products are another solid decumulation plan. If you need your assets to pass to your loved one's after death, both will make sense to invest in as those highly taxable assets can grow tax-free and in some cases can be passed on or drawn down during your living years.
It might be wise to think about gifting some of your assets to avoid higher tax brackets. Qualified charitable contributions can help avoid the IRMAA cliff.
Thanks for your attention and interest. This post discussed the Decumulation Phase of Retirement and how it could affect your budget. Hopefully, that helps you plan well for your retirement.