Planning Your Retirement: The Best Ways to Generate Lifetime Income

CBS MoneyWatch

How much retirement income can you get from your 401(k), IRA, and other savings? That's a critical question as you piece together your various sources of retirement income, which also includes Social Security, pensions, and continued work. Surveys show that many people struggle with the difficult task of generating lifetime retirement income; this post will help you tackle this challenge.

Welcome to Week 6 of my series, "12 Weeks to Plan Your Retirement."

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One way not to manage your retirement income: Many retirees just withdraw what they need from their savings to meet their living expenses, without considering that they'll need to make these savings last for the rest of their lives. Most people withdraw too much, with the unfortunate result that they'll exhaust their retirement savings when they still have many good years of life remaining.

To avoid this unpleasant fate, you should set up a method of generating retirement income that is most likely to make your savings last for your lifetime and, if you're married, for your spouse's lifetime as well.

There are three basic ways to meet this goal:

1. Invest your retirement savings and use just the interest and dividends.

2. Invest your retirement savings and withdraw principal carefully.

3. Buy an immediate lifetime annuity from an insurance company.

There are many variations on each of these methods, and they all have their advantages and disadvantages. There's not one magic bullet that works best for everybody, so you'll want to learn more to see which method, or combination of methods, works best for your circumstances.

How much lifetime retirement income can your savings generate? A 65-year-old can reasonably expect to generate an annual retirement income of between 3 and 7 percent of savings. That's quite a wide range, so it pays to learn the benefits and drawbacks of different approaches.

Here are a few ways to research different approaches and figure out how much income they will generate, based on your portfolio:

• If you're planning to use interest and dividends without drawing down principal, I suggest investing in a good no-load mutual fund balanced between stocks and bonds. You can estimate the amount of annual income you'll receive by looking at the dividend distributions from the fund in the last year; make sure to exclude capital gains distributions.

• If you want to withdraw principal carefully, an important decision you'll need to make is the percentage of assets that you'll withdraw each year. There are several ways to do this: You can use the 4 percent rule or a variation thereof; you can use a Monte Carlo method, such as the calculator on the T. Rowe Price website, or you can use the simple online tool that I've written about previously.

• If you want to buy an immediate annuity, you'll need to choose between a fixed annuity, an inflation-adjusted annuity, or a variable annuity. You can estimate how much you'll receive by using online annuity purchase services such as www.immediateannuities.com, Vanguard's Annuity Access program or the variable annuity site through Vanguard.

One important consideration for determining how much money you'll have to spend in retirement is the amount of income taxes you'll have to pay on your retirement income.

• For income that's coming from a tax-advantaged savings vehicle such as a traditional 401(k) plan or an IRA, all your income will be subject to ordinary income taxes, regardless of the method you choose for generating retirement income.

• If you're generating income from a Roth IRA or Roth 401(k), none of the retirement income is taxable.

• If you're generating income from ordinary savings or investments accounts, or from annuities purchased outside an IRA or 401(k), the part of your retirement income that is investment earnings will be taxed, while the part of your retirement income that is return of principal isn't taxed. This last calculation might be difficult for you to nail down -- you'll either need to make an educated guess or get your accountant or financial advisor involved.

Finally, if you're married, make sure that the retirement income you generate lasts for both your lifetime and your spouse's.

As with many steps in this 12 week series, your homework this week might take more than a week to complete. That's OK -- it's very important that you take the time to secure a paycheck that will last the rest of your life. You'll thank yourself 20 or 30 years from now when you're still enjoying your retirement income, and your less diligent friends and relatives are broke and needing to return to work.

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