One of the most important steps you can take before leaving the workforce is designing a retirement income plan that replaces the steady paycheck your career once provided. Without a clear plan, you may find yourself relying too heavily on investment returns or withdrawing assets inefficiently - putting your lifestyle and longevity at risk.
There are several popular approaches to generating income in retirement, including:
- The Bucket Strategy: Segmenting your assets into short, medium, and long-term "buckets" based on when you’ll need the funds. Short term funds are held in cash, long-term assets in equities and medium-term assets in stocks and bonds.
- The Total Return Strategy: Drawing income from a diversified investment portfolio in the form of both dividends and sale of shares. In this case, the investments are focused on overall return rather than specific income-producing assets.
- The Income Strategy: Relying on interest, dividends, and other yield-focused investments to provide income.
- The Guaranteed Income Strategy: Using predictable, lifetime income sources—like Social Security, pensions, and annuities—to cover your essential living expenses and withdrawals from the portfolio to pay for discretionary spending.
Over the years, I have used each of these methods. While each strategy has merit, my preference is the Guaranteed Income Strategy for two reasons:
- It most closely replicates the paycheck we are used to getting during our working years.
- It’s easily understood and seems to provide a degree of comfort and familiarity to our clients.
This post focuses on generating guaranteed income to cover your non-negotiable, monthly expenses and periodic withdrawals from the portfolio to cover discretionary spending.
Split Your Income Into Two Buckets: Needs vs. Wants
The first step in the retirement income planning process is to divide your income needs into two broad buckets – fixed monthly bills and periodic, discretionary expenses:
1. Covering Your Fixed Expenses with Guaranteed Income
Think of this as your "retirement paycheck"—a reliable stream of income that arrives every month, no matter what the markets are doing. These dollars are best used to pay for essential costs like housing, healthcare, groceries, insurance, and utilities.
Guaranteed income sources might include:
- Social Security – Maximize this by delaying benefits when appropriate.
- Pensions – Evaluate payout options with your advisor.
- Annuities – Can be used to fill income gaps and provide lifetime income.
- Rental Income or Reverse Mortgages – May provide steady income depending on your situation.
- Part-Time Work – Offers supplemental income and purpose in early retirement.
This approach offers some comfort, knowing that your core lifestyle is preserved regardless of market volatility.
2. Using Flexible Withdrawals for Discretionary Spending
For travel, hobbies, gifting, and other occasional “wants,” it’s wise to maintain flexibility by drawing from taxable accounts, traditional IRAs or 401(k)s, Roth IRAs, and/or cash reserves. These withdrawals don’t need to happen monthly. In fact, taking irregular or lump-sum withdrawals allows you to adapt your spending year by year based on market performance and personal goals. As these expenses are discretionary, you and your advisor can often time the withdrawals to coincide with positive market performance.
Tax Efficiency Matters—A Lot
One of the biggest mistakes retirees make in their retirement income planning is not planning for taxes.
Different income sources are taxed differently:
- Traditional IRA/401(k) withdrawals: Fully taxable as ordinary income.
- Social Security: Taxed as ordinary income but only a portion of your benefits are taxed. In some cases, benefits may be tax-free depending on your total income.
- Pensions and annuities: Typically taxed as ordinary income. Some annuities may only tax a portion of the withdrawal while the remainder (basis) is tax-free.
- Roth IRA withdrawals: Tax-free if qualified.
- Dividends and capital gains: Long term gains and qualified dividends are often taxed at lower, more preferential rates while short term capital gains and non-qualified dividends are taxed at higher income tax rates.
Here’s a deeper dive into a tax-efficient withdrawal strategy that we often use with clients that makes sense for many retirees:
Smart Withdrawal Strategy: Fill the Lower Brackets First
One of the most powerful levers in retirement income planning is deciding which accounts to draw from, and when. By coordinating withdrawals across tax-deferred, taxable, and tax-free accounts, you can minimize your lifetime tax bill—not just your taxes this year.
Step 1: Start with Tax-Deferred Accounts
Begin by withdrawing from traditional IRAs, 401(k)s, and other tax-deferred accounts, especially in the early years of retirement before required minimum distributions (RMDs) kick in. These withdrawals are taxed as ordinary income, so the goal is to "fill up" your lower tax brackets—such as the 10%, 12%, or even 22% brackets—while avoiding jumping into higher ones unnecessarily.
Why this works:
- You take advantage of low federal tax brackets in years where your income is otherwise modest.
- You proactively reduce the balance of tax-deferred accounts, lowering future RMDs and possibly avoiding Medicare IRMAA surcharges or the Net Investment Income Tax (NIIT) later in retirement.
This is especially important for retirees who delay Social Security or don’t have significant other income sources in early retirement. It creates a window of opportunity for strategic withdrawals or even Roth conversions.
Step 2: Tap Roth and Taxable Accounts as Needed
Once you’ve filled the lower tax brackets with tax-deferred withdrawals, any additional retirement income can come from more tax-advantaged sources:
- Roth IRAs or Roth 401(k)s: Withdrawals are tax-free, assuming they are qualified. These are ideal in years when you're close to pushing into a higher tax bracket or triggering income-related penalties like IRMAA.
- Taxable brokerage accounts: Withdrawals may be taxed more favorably, especially if you’re realizing long-term capital gains, which are often taxed at 0%, 15%, or 20%, depending on your income level. Additionally, qualified dividends from taxable accounts may also receive preferential tax treatment.
- By layering withdrawals from different account types, you gain flexibility and can customize your income in a tax-efficient way depending on your cash flow needs, market performance, and tax environment in any given year.
Example in Practice:
Let’s say a newly retired couple has no pension and hasn’t started Social Security. Their spending need is $100,000/year. They might:
- Withdraw $60,000 from traditional IRAs to stay within the 12% federal tax bracket.
- Take $20,000 from a taxable account, realizing long-term capital gains taxed at 0%.
- Pull $20,000 from a Roth IRA, tax-free, to avoid jumping into the 22% bracket.
The result: they meet their full retirement income need while keeping their effective tax rate low - possibly even below 10%.
Retirement income planning is incredibly nuanced and needs to be tailored annually. It’s also an area where partnering with a financial advisor and tax professional can add significant value over the course of a 25 – 30 year retirement.
When designing these types of income plans, you’ll need to beware of income thresholds that trigger additional taxes or penalties:
- IRMAA surcharges on Medicare premiums for higher earners
- The Net Investment Income Tax (NIIT) for certain taxpayers with investment income
- A well-designed retirement income plan helps you balance current spending needs with long-term tax efficiency
Plan for Inflation—and Changing Needs Over Time
Your income needs won’t remain static. In early retirement, you may spend more on travel or home projects. In later years, spending often shifts to healthcare and may decrease overall. But many guaranteed income sources don’t adjust for inflation, so purchasing power can erode over time.
That’s why it's crucial to:
- Include investments that grow to combat inflation.
- Re-evaluate your income sources and expenses annually.
- Adjust your plan as tax laws and your personal circumstances change.
Your Retirement Income Plan is Not “Set It and Forget It”
Retirement is a long journey—often 25 to 30 years or more. As your needs evolve, your retirement income strategy should evolve with it. Revisit your plan each year with your financial advisor to:
- Track spending and income
- Adjust for tax changes
- Reassess inflation assumptions
- Review Social Security strategies or annuity income options
- Align investment withdrawals with current goals and tax brackets
Conclusion: Build the Plan Before You Need It
The most successful retirees don’t just hope their savings will last - they proactively create a retirement paycheck that blends guaranteed income with flexible withdrawals. By developing a thoughtful retirement income strategy before you leave work, you can transition into retirement with confidence, clarity, and control.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply