Retirement Income Planning in Pennsylvania is simpler than in many other states because PA does not tax retirement income sources such as social security benefits, pension income, and IRA distributions.
John and Jane plan to retire in 2021. They plan to stay in the state of Pennsylvania, at least initially, during retirement. John will be age 66 at retirement and Jane will be age 62. The retirement cash flow statement above was created to help John and Jane with their retirement income planning.
Creating an organized retirement cash flow statement is an important part of their comprehensive plan preparing them for retirement.
Target Retirement Year
Column A shows the year. The first year shown is 2021, their target retirement year. This example only shows the years 2021 through 2031. The cells in the excel sheet can also be extended downwards to show 20 years, 30 years, or longer.
Estimating Retirement Expenses
Column B shows an estimate of their annual retirement expenses. The assumptions used are displayed in rows 1, 2, and 3 of the excel sheet. John and Jane just paid off their mortgage and their expenses are about $5k per month currently.
Once they retire and lose employer health insurance, healthcare costs will go up. Because John will already have obtained age 65 when he retires, he’ll be able to enroll in Medicare right away.
Jane will only be 62 at retirement, so she wont’ be eligible for Medicare. Jane will need to find private health insurance or enroll in COBRA prior to reaching age 65. As a result, her healthcare costs are likely to be significantly higher prior to obtaining Medicare eligibility at age 65.
You can see above in Column B Row 10 that, in the year 2024, expenses decrease. This is because Jane is now 65 and is eligible to enroll in Medicare, which reduces healthcare costs. The healthcare costs in the table above may be higher than what Pennsylvanians actually pay once they’re Medicare eligible, but it’s conservative and builds a margin of safety into the retirement plan.
More information about Medicare, Medicare Supplement Plans, and costs specific to Pennsylvania can be found in this article: What is the Best Medicare Supplement Plan in Pennsylvania?
The expense estimates in Column B continually increase during retirement due to inflation. Inflation has averaged around 3% per year when looking back from 2020 to the early 1900s.
However, inflation has been lower recently. As a result, some retirement plans will assume lower inflation rates such as 2% or less. Using low inflation rates is a sign of poor planning: it's risky to use low inflation rates because it may cause you to underestimate your future retirement expenses.
The average inflation rate experienced by consumers of goods and services in the economy as a whole does not necessarily reflect the inflation you’ll experience during your retirement due to healthcare costs. Medical costs are increasing at a rate that far outpaces the average of all goods and services.
Depending on the study and the data used, medical costs have inflated by around 6% per year in recent history. The scenario in the cash flow statement above assumes a blended average annual inflation rate of 3.5% for all expenses, including both healthcare and non-healthcare costs.
The inflation assumption can be edited to show a scenario with 4% or higher annual inflation as well. With the rate at which we are printing money, inflation is a threat to retirement security that needs to be carefully monitored.
Retirement Income from Social Security
Column C and Column D show retirement income from social security benefits. John’s social security retirement income starts out around $36k per year, and Jane’s social security retirement income starts out at close to $25k per year.
John starts collecting his social security retirement income at age 66, and Jane collects hers at age 62. They decide to start their social security income right when they retire because this allows them to take less money out of their investment accounts initially.
John and Jane prefer to start receiving social security retirement income now and preserve more of their investments for later. The retirement cash flow statement above assumes Social Security income increases by 1.6% per year because that was the actual cost of living increase in 2020.
In reality, the cost of living increase changes each year, and there’s a possibility it could be eliminated in the future. The assumption of a 1.6% annual cost of living adjustment for social security benefits can be edited to show an alternative scenario with a lower cost of living increase, or no cost of living increase at all.
If John dies first, Jane will switch to the social security survivor’s benefit, which will be an amount equal to John’s retirement benefit at the time he dies (based on rules as of 2020). Jane will stop receiving her own social security benefit if she does this.
If Jane dies first, John will continue collecting his own benefit and Jane’s benefit will stop. Other retirement income strategies related to social security, such as claiming the spousal benefit, can be built into the retirement cash flow statement.
Pension Income
Column E shows John’s pension from a previous employer. The pension pays $1,200 per month. They elected the 50% survivor option so that if John dies first, Jane will continue to receive income, but it will be reduced to $600 per month. This pension does not have a cost of living adjustment. The pension will pay the same $1,200 per month for as long as John lives and will never increase.
Gross Income
Column F adds up pension and social security income to arrive at the “Gross Income” figure. Gross Income is the pre-tax amount of annual retirement income John and Jane will receive without including income from investment accounts or part time work yet. Retirement income strategies related to investment accounts and part-time work will be discussed below.
After-tax Retirement Income
Column G shows retirement income after taxes are taken out. This example assumes a 15% average income tax rate. To be conservative, this assumption is likely higher than what John and Jane will pay in reality, especially in Pennsylvania which does not tax retirement income at the state level. The image below shows federal income tax rates as of 2020.
Because John and Jane are married and file jointly, income up to $19,750 is taxed at 10% and income between $19,751 and $80,250 is taxed at 12% in 2020 numbers. Based on the retirement cash flow statement above, their gross social security and pension income will be about $75k in 2021.
They may have other income such as interest and dividends that would need to be added in to determine their tax bracket, but they’ll also be able to subtract at least the standard deduction which is about $25k in 2020. The 15% average income tax rate is a fair assumption in this scenario, and the assumed tax rate can also be edited to show an alternative scenario with a higher future tax rate as well.
Image credit: Nerdwallet
Retirement Income: Shortfall or Surplus?
Column H shows the projected retirement income shortfall or surplus. In this example, John and Jane will have a retirement income shortfall of about $20k per year initially. The income shortfall will increase slightly each year due to inflation. In 2024, the income shortfall drops because expenses went down as a result of Jane reaching age 65 and qualifying for Medicare.
Beyond 2024, the retirement income shortfall continues to increase each year because expenses continue to increase as a result of inflation. Social security income receives a cost of living increase in this example, but it’s not high enough to keep pace with healthcare cost inflation.
The pension does not increase at all. As a result, the retirement income shortfall expands year after year. A fiduciary financial advisor with retirement planning expertise can help you set up retirement income strategies that increase income over time with inflation. Accounting for inflation, especially healthcare cost inflation, is a very important component of effective retirement planning.
How will John and Jane fill their Retirement Income Shortfall?
Depending on personal preferences and financial resources, John and Jane may choose to fill their retirement income shortfall with part-time work, investment income, or a combination of both.
Part-time work. If John and Jane can generate about $20k per year in net income from part-time work during retirement, they can let their IRAs and other investment accounts continue to compound and grow for later.
Investment income. Their investment accounts can be setup to payout monthly income to fill their shortfall. In 2021, John and Jane are projected to need about $1,667 per month after-tax to fill their $20k per year retirement income shortfall. If the investment income is coming from a Traditional IRA account or other pre-tax retirement plan, federal taxes can be withheld up front (state tax should not be withheld in Pennsylvania). If federal taxes are withheld at 15%, a gross income distribution of $2,000 per month will pay them $1,700 per month after-tax, which projects to be enough to fill their retirement income shortfall. Any income from part-time work will reduce the amount that needs to be distributed from investment accounts.
The Retirement Income Shortfall grows over time because of inflation. How can John and Jane plan for this?
After going through retirement income planning and building a retirement cash flow statement, John and Jane are now prepared to create a well-organized investment plan for retirement. The investment plan must balance the need to protect their money while also growing it enough to fund a potentially very long, extended retirement. A sound investment plan for retirement has three primary components.
FDIC insured bank accounts. The purpose of this component of the investment plan is liquidity and protection from market fluctuations.
High-quality bonds or bond funds. This provides protection from stock market fluctuations. Bonds aren’t essential in all cases.
High-quality stocks and stock funds. The purpose of this piece of the investment plan is to provide protection from inflation and growth to fund a long, extended retirement.
Retirement income planning is a critical component of a well-organized, comprehensive retirement plan. Retirement income planning is a precursor to building an effective investment plan for retirement.
Among other things, a fiduciary financial advisor with retirement planning expertise can help you design a fully coordinated and well organized income plan and investment plan for your retirement.
Would you like a 1-on-1 retirement planning consultation? Fill out the “Request Consultation” form, call us at 267-427-5667, or email kyle.rolek@rolekretirement.com