Generating enough income to live comfortably during retirement is one of the biggest challenges that every American may face later in life.
In 2014, the Insured Retirement Institute (IRI) asked Baby Boomers what they considered their top-five retirement income sources. They found that Social Security tops their list. In fact, research shows that 65% of Americans age 65 and older receive about half or more of their retirement income from Social Security.
Following Social Security, in order of prevalence, are traditional employer-provided pensions, 401(k) or defined contribution plans, personal investments, and individual retirement accounts (IRAs).
But financial planners warn that retirees should be balancing their income streams, not just relying on a single source or two, especially since Social Security may not come close to covering your expenses. Recent research suggests that it may not even cover out of pocket medical costs let alone housing and food.
Here’s what you need to know about the top-five retirement income strategies:
When you work, you pay taxes into Social Security. That money is then used to pay for Social Security benefits, which are collected by retirees (typically starting at age 62), workers who become disabled, and families in which a spouse or parent dies.
But even the Social Security Administration advises that Social Security should act only as a supplement to other retirement income streams (not as the sole source). The benefits replace about 40% of an average worker’s income after retiring, but most financial planners say retirees will need 70% or more of their pre-retirement earnings to live comfortably.
“Social Security was never meant to be the only source of income for people when they retire,” the agency writes in a report. “To have a comfortable retirement, Americans need much more than just Social Security. They also need private pensions, savings and investments.”
A traditional pension, or “a defined benefit plan,” is an employer-sponsored plan in which you are scheduled to receive a certain benefit (based on salary and years of service) in your retirement years. Traditional pensions are called defined benefit plans because the value of the benefit is defined in terms of a set monetary amount at the time of retirement.
Like Social Security, though, pensions are becoming a less reliable source of income for retirees, as fewer employers are willing to sponsor traditional pension plans.
“The only people I know that are getting pensions are government employees,” Chinn says. “Teachers also get a reasonable pension, but most people in the private industry aren’t going to be getting pensions because more companies are heading away from pensions and toward defined contribution plans.”
In defined contribution plans, the employee or the employer (or both) contribute to the employee’s individual account under the plan. The employee will ultimately receive the balance in their account, which is based on contributions–plus or minus investment gains or losses. So, the value of the account may fluctuate due to the performance of your account’s investments. One common defined contribution plan is a 401(k).
These plans, among other strategies, are what Americans should be focusing more of their attention on, Chinn says.
“For the average worker, the shift in retirement planning strategy should be [toward] a combination of tax-deferred/401(k)-type plans and taxable investment savings,” he says.
There is a host of investment options out there that you can use to generate income during retirement. Two great choices are immediate annuities and laddered bonds, says Kevin McGarry, director of the Nationwide Financial Retirement Institute.
Many households are confused about retirement investments.
“Every person has a different lifestyle and expectation in retirement,” he says. “And most have a different income going into retirement, which is one reason we suggest spending time with a financial planner who will incorporate assets you have today, Social Security as a component, the cost of health care, plus looking at what are the right investment choices today to build out your plan.”
An IRA is an account set up at a financial institution that allows you to save for retirement in a tax-advantaged way. There are three main types of IRAs:
- Traditional IRA: you can make contributions with money you may be able to deduct on your tax return and any earnings can potentially grow tax-deferred until you withdraw them in retirement.
- Roth IRA: you make contributions with money you’ve already paid taxes on (after-tax) and your money may potentially grow tax-free, with tax-free withdrawals in retirement, as long as certain conditions are met.
- Rollover IRA: is a Traditional IRA intended for money “rolled over” from a qualified retirement plan, such as a 401(k).
A Roth IRA often makes the most sense, Chinn says.
“The thing that people don’t understand about tax-deferred IRAs is that at age 70 ½ they start having to withdraw and paying taxes at a regular income level on that money,” Chinn says. “Nobody knows what tax rates are going to be in the future; if tax rates are going to go up, then it’s better to pay them now when you know what the rate is.”
With a variety of planning strategies out there, you should consider all options for generating additional income during your retirement years, especially if trouble is ahead for the top-two strategies. Chinn even suggests retirees flip the list and focus more of their attention on IRAs, personal investments, and defined contribution plans.
“We have to find a way to educate people better so that they understand what their retirement needs are,” he says. “It’s as simple as saying, ‘How do you want to live in retirement and what things do you want?’ and having a spreadsheet showing, ‘This is how much money you’re going to need, now let’s figure out where that’s going to come from.’”
Need help? Consider getting matched to a retirement financial advisor or using an easy and reliable retirement calculator.
