Five Pillars of Retirement Income

Five Pillars of Retirement Income

Financial advisor, Michael Kitces, says, “The modern retirement portfolio will really rely on four pillars for retirement income – interest, dividends, capital gains, and principal.”

Most Americans can add Social Security as a 5th retirement income pillar, and in this article, we’ll examine these 5 post-employment income sources, their tax consequences, and how they might combine to sustain you when you’re hoping to do more of what you want to do each day rather than what you must do.

If you hope to stop working someday, or at least slow down, you MUST think about where your income will come from in those years. Most people bop through life, thinking their long-term finances will just “work out somehow.”

Of course, you can go to almost any home-improvement, big-box, burger-and-fries, or mall store, and you’ll see them – people in their late 60’s and 70’s behind the counter or greeting you at the door or handing out food samples or collecting shopping carts, who found out too late that it won’t just work out.

Work it out

It’s your responsibility to make sure your finances work out over your whole lifetime. If you’re ready to do that, we’re always ready to help.

Let’s start by examining the Five Pillars of Retirement Income.

Interest

Interest is the payment you receive for letting someone else hold AND USE your money. If you have a bank account, and you leave money in it, you will be paid a (pitiful) interest rate on your account balance. Whatever the annual rate is, you’ll likely be paid 1/12 of that amount each month.

There are other common sources of interest, such as the coupon on bonds. When you purchase a bond, whether you do it directly or through a mutual fund, you are lending the bond issuer your money, and they are committing to pay you a set interest rate (coupon) over a set number of years. At the end of that time, they promise to return your original investment.

You can also earn interest on the cash value inside a permanent life insurance policy, on your balance in a money market account, and more.

Interest paid to you is considered income by the IRS, and is taxed at your income tax rate.

Dividends

Dividends are an owner’s share of an enterprise’s profits.

If you are a 50% owner in a business, you would be entitled to 50% of the company’s profits. If you’re a shareholder in a company, you are one of the owners, and are therefore entitled to your proportionate share of the company’s profits.

Dividends are taxed as income.

Capital Gains

If you purchase part or all of something of value, and you sell it after it has increased in value, the amount of the increase is a capital gain.

Common sources of capital gains include an increase in the value of stocks you hold individually or through a mutual fund, the value of your personal residence, the value of investment real estate properties, and the value of virtually anything else you can sell at a higher price than you paid for it.

There are adjustments that allow you to decrease the capital gain, if you contributed to the value of the asset while you owned it, but however it’s ultimately calculated, the IRS generally taxes a capital gain at a lower rate than income.

Capital gains tax rates vary from as low as zero for low-income individuals to as high as 28% on collectibles. For most people in most situations, the capital gains tax rate is 15%.

Principal

Your principal is your money.

This is money you’ve accumulated after taxes, and you’ve saved it or invested it. If it’s in a bank account, it’s called the balance. If it’s in an investment, it could be called your basis. If it’s in a permanent life insurance policy, it’s called cumulative premium.

Since the IRS acknowledges that this your money, there are no taxes due if you take it out of an account to spend.

Social Security

Regardless of your politics, you can be confident that – as long as there’s a United States government – there will be some form of Social Security program. It is a social contract no politician would dare suggest we eliminate, and Washington will continue to find ways to breathe life into it.

The average monthly Social Security check is currently $1,229. That’s $14,748 a year. Well below the poverty level, so Social Security alone will not sustain you.

The Five Pillars

As you consider how to pay life’s expenses in the years when you won’t feel so much like working, consider how you will use each of these 5 income sources.

If you’re fortunate enough to have set aside a large amount in interest-bearing accounts, you may be able to cover your living expenses with interest income and Social Security. Both Social Security and interest income are taxable, so depending on what the combination adds up to each year, you may have an income tax liability.

Dividends from investments will also add to your combined income for tax purpose. If you sell property or securities for a profit, you can add capital gains to the tax calculation.

The critical result you’re seeking is for your “after-tax” retirement income from the 5 pillars to be more than your living expenses at that point in your life.

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11 Responses to Five Pillars of Retirement Income

  1. Hi there! This post could not be written any better!
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    Thank you for sharing!

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