What Money Should You Use First In Retirement?

Most successful retirees will have three sources of money for retirement:

  1. Qualified: IRA, 401(k), 403(b), Thrift Savings Plan, etc. that they contributed to during their working years for use during retirement. Income taxes have not yet been paid.
  2. Social Security: Virtually every private-sector worker is eligible for Social Security during their retirement years. Also, a non-working spouse of a qualifying worker is generally eligible to receive at least one-half of what the working spouse qualifies for at normal retirement age.
  3. Savings and investments: These are your other savings you’ve set aside for retirement or to pass on to the next generation. This pool of money is sometimes called non-qualified money because income taxes have mostly been paid or lower tax rates apply – for example capital gain taxes or taxes on stock dividends.

Two of these sources have age restrictions. Social Security can be taken as early as age 62 (earlier if disabled or there are other special circumstances) and should be started no later than age 70 because this is age when benefits peak based on the mortality tables. You are generally penalized for using your qualified money before age 59-1/2; however, there are numerous exceptions. You must start withdrawing a minimum amount from your qualified retirement money when you reach age 70-1/2. Of course, you can convert your qualified retirement money to a Roth IRA which allows you more latitude in its use. You can use your non-qualified savings and investments at any age or you can bequeath these moneys to others at your death.

What about taxes? Your Social Security benefits will always receive favorable tax treatment. Of course, the more income you have the greater will be the income taxes on your Social Security benefits. But, under current law Social Security benefits are always tax favored. Your qualified retirement money will be taxed at your normal income tax rate when you begin to withdraw it – and remember you must start taking required distributions at age 70-1/2. You can convert your qualified money to a Roth IRA and pay the taxes all at once and then enjoy tax-free income indefinitely into the future. Converting to a Roth IRA makes sense for some but not other; therefore, you’ll want to get professional advice before converting to a Roth IRA. Your non-qualified savings and investments generally have the least amount of taxes due when used because you’ve already paid income taxes or they receive special treatment such as capital gains or dividend income.

What happen at your death? For Social Security, your spouse will be eligible to get the greater of what he or she qualified for on their own or as your dependent OR whatever the deceased spouse was receiving. This spousal benefits is very important because it will be received as long as the surviving spouse lives – which could be a very long period of time. If the deceased spouse elected to postpone Social Security until age 70, that means the surviving spouse will get a much larger amount than if the decreased spouse started early at age 62. For qualified money such as IRA, 401(k), 403(b), etc. it can generally be passed tax free to the surviving spouse, or others, and they will pay taxes at their normal rate. Generally payout must occur over their remaining lifetime. There are methods whereby you can stretch payout if left to non-spousal heirs and I encourage you to speak with your financial advisor about this if you do not plan to use all your qualified money during your lifetime. Your non-qualified savings and investments are part of your estate and can pass to whomever you elect at your death. I’ll not comment on the tax consequences of these money but will encourage you to get professional advice from a financial planner, attorney and CPA if you have a sizable estate that will pass to others at your death. This is very important if you wish to prevent the Government from being your beneficiary.

Now that I’ve set the stage, which of your money should be used first in retirement? Of course it depends on your individual circumstances but the average retiree that can afford to postpone Social Security until age 70 will generally benefit. Why? Because, the money is always tax-favored so you want a relatively larger portion of your retirement money to come from Social Security. Since Social Security benefits grow about 8% for each year postponed PLUS a cost of living adjustment (making total growth about 11% annually), you can’t beat this rate of return with any other safe money investment. Add to this exceptional growth the spousal benefits and the lower tax rates and you have a powerful reason to postpone Social Security for as long as possible. I know, you’re worried about dying before you reach the break-even age of about 80 – remember the spousal benefit and look at the mortality tables. You’ll find that there is almost a certainty that one or both of the average married retirees will live into their 90’s which is well beyond break-even age. So, contrary to conventional wisdom, postpone your Social Security if you can afford to – especially if the wife is a few years younger than the husband and the husband was the principal breadwinner. What, you’re worried that Social Security will be eliminated by Congress? Think about the 50 million now getting Social Security benefits and 78 million more (the baby boomers) now turning Social Security age! That a powerful voting block that Congress knows will vote them out of office if they tamper with Social Security too much. Social Security is not going anywhere – it will be available for the remainder of your life.

Okay, so you postpone Social Security: what about your qualified money like IRA, 401(k), etc.? You know that 100% of your withdrawals will be subjected to ordinary income taxes…and they’ll also help determine the income taxes you’ll pay on Social Security benefits. No tax breaks here. Which way to you think income taxes are headed? Me too – higher and higher because of a sea of red ink from national debt, rising deficits and excessive federal expenditures which will continue unabated. So, by taking this money first you (a) will pay lower taxes now rather than higher taxes later and (b) you’ll be taking less of this money later when Social Security benefits starts, meaning you’ll pay fewer taxes on these benefits. Of course, if you think taxes are going to go down (are you crazy?), you might conclude this sequence of use is backwards. But, you’d be wrong if you run the numbers as I did in my publication The Guide to Social Security…and A Better Retirement. (link below).

What about the your non-qualified savings and investments? You should use these to bridge the income gap as needed and for emergencies. Again, if you have more money than you’ll need in retirement, get professional help so that taxes can be minimized when this money passes to your heirs at your death.

In the past year there has emerged a lot of chatter about delaying Social Security…and the conventional wisdom of taking it first (which almost three-fourth of Americans do) is dead wrong. You don’t agree? Well, remember that at one time the conventional wisdom said the earth was flat, but we know different now. At one time the conventional wisdom was take Social Security at age 62 but we now know that is wrong for most folks. If you started early and it was a mistake, I wonder what other financial mistakes you’ve make with your retirement money? If you’re wondering too, I recommend you get professional help so you can have a better retirement.