We just finished upgrades to our optimal retirement income calculator to include the possibility of having excess retirement income. This situation occurs when Required Minimum Distributions (RMDs) + other non-discretionary sources of retirement income exceed the retiree’s needed income in current and future retirement years. Indeed, this is a good problem to have! It typically occurs when annual retirement income needs are small relative to all the retiree’s income sources. Retirees in this situation have an extremely low risk of outliving their assets.
For example, consider a retiree who needs $100,000 of income in their first year of retirement. What should a retiree do if their RMDs are $40,000, pension and social security benefits are $50,000, and interest + dividends in taxable accounts are $20,000, for a total of $110,000? Note: This $10,000 of excess retirement income occurs without taking voluntary withdrawals from any of their accounts. How should a retiree invest this money to maximize tax efficiency?
Retirement Income Sources
As we show on our updated FAQ page, we included many possible sources of retirement income. To help simplify the model, we previously required dividends and interest in taxable accounts to only satisfy immediate retirement income needs. We make a similar assumption of social security and any pension benefits. Put another way, we wouldn’t re-invest these funds for later use in retirement. Thus, the taxable account maintains a single cost basis from investments made prior to retirement.
What about Required Minimum Distributions (RMDs)?
Required Minimum Distributions (RMDs) complicate retirement income planning, and represent non-voluntary account withdrawals. They can also produce the unintended consequence of producing excess retirement income, like in the example above.
Tax Efficient Investing of Excess Retirement Income
We upgraded our model with a simple approach to reinvesting excess retirement income that would never be needed by a retiree. As previously advocated by DiLellio and Ostrov (2020) and DeMuth (2020), zero-dividend equity (e.g. stock) investments offer a solution. For example, the largest zero-dividend ETF is the First Trust Dow Jones Internet Index Fund (ticker: FDN). By reinvesting excess income into an ETF like this one, no gains during retirement would be realized. So, no taxes are due. Then, the total amount in this investment account can be passed to the retiree’s heirs tax-free thanks to a step-up in cost basis, but excluding estate taxes. Below is an image that shows the new black line to track the account holding the excess income that, in this example, starts in year 7.
We hope you find this new enhancement helpful in planning for your retirement! Please stay tuned for future enhancements to our web-based calculator, including evaluating the benefits of municipal bond ETFs, Roth conversions, and automating sensitivity analyses.
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