Continuing the theme of Financial Literacy Month, I will define terms that will help you create a plan for retirement income, particularly as it relates to taxes and risk management.

The key to a successful retirement income plan is to increase your spendable income (money after taxes paid). So you might want to know a lot more about taxes.

financial literacyYou also want to make it dependable income (money you can count on). You want your income to be predictable and stable, like Social Security or a company pension. It all means that you are going to want to understand risk management.

Tax Terms

Retirement income sources are affected by taxes and, in retirement just as during your working years, you can take steps to reduce your tax bite. Your later years should bring multiple joys, but for many of us the government has created a new tax day that, while we may not look forward to it, we must at least acknowledge.

The Basics: Taxable, Tax-Deferred, Tax-Favored, Tax-Free

Different types of retirement income are taxed differently. Pay attention to those differences to create as much spendable (after-tax) income as possible.

Tax-free income typically only comes from the interest on municipal bonds. However, distributions from a Roth IRA can be tax-free. Of course, you have likely already paid taxes on the money you invested in a Roth IRA.

Tax-deferred refers to accounts like a 401(k) or IRA that allow you to invest money that you don’t pay taxes on while you are working. In return, the tax bill comes due when you make withdrawals. See below for a discussion of RMDs.

Tax-deferred annuities let you defer taxes on investment earnings, again until withdrawal. See below for a discussion of LIFO taxation.

Tax-favored earnings represent dividends and long-term capital gains that are taxed at a lower rate than interest and so-called ordinary income that are fully taxable. Some consider the income from a non-qualified income annuity as tax-favored. (I touch on this more below.)

Creating retirement income from a variety of sources will help keep taxable income as low as possible. Make sure to ask your accountant or financial advisor about how to minimize taxes. That’s important every time you meet, but especially as you get closer to retirement.

Distributions from Tax-Deferred Accounts

The day you turn 70½ is the day you are compelled to start receiving Required Minimum Distributions, or RMDs out of your IRA. As I wrote in more detail in this article, your contributions to a traditional IRA are not taxed when you add them to your account. The government does assess a tax when you start taking distributions, which you can do as early as 60, and you must do no later than 70½.

It’s the government’s way of finally generating revenue on the money you saved and the interest those savings earned. So, if your RMDs are a large part of your retirement income, you might have less spendable income than it first appears.

You can get a small tax break from a QLAC. By investing a portion of your 401(k) or Rollover IRA in a QLAC, you can defer some of your RMDs until 80 or 85, when QLAC payments begin.


Two terms familiar to manufacturers but not so much to consumers are LIFO (Last In, First Out) and FIFO (First In, First Out). When items are stored in a warehouse, a manufacturer might choose to sell those that were stored first, or those that were moved in last, depending on taxes and other financial considerations.

For a regular taxpayer, LIFO and FIFO come into play when you buy a tax-deferred annuity by making one or more payments to an insurance company that will allow you to access the money plus earnings later.

Say you put $100,000 into a deferred annuity and it grows over time to $150,000. At that time, you decide to withdraw $6,000 to pay for retirement expenses. The government taxes the $100,000 investment differently than the earnings, which are considered “last in” because they consist of interest that built on the initial investment. The government’s LIFO rules call for your $6,000 withdrawal to be 100 percent taxable at your current rate.

You can spread out some of the tax bite by converting the $150,000 into an income annuity that will pay you annual income. In that scenario, a portion will be taxed as earnings, and some will be excluded as a return of the original investment.

Risk Management

You have heard the term asset allocation, which advisors urge as a way to diversify your investments to balance the threat of losses in a single area. When stocks fall, for example, bonds may balance or modulate the loss. You can also diversify between different types of stocks and bonds.

I believe it is even more important to consider product allocation: Where do you invest money that is designed to create income? Where is money you can use in an emergency or for unexpected expenses? What products will provide a financial legacy for your heirs? Many advisors tend to mention only the products they’re licensed to sell, so it’s up to you to study the types of financial products you are interested in, and to ask your advisor about them.

Income protection

Some variable annuities, which are invested in the stock market and thus might rise and fall, offer income protection in the form of a living benefit guarantee. (I am familiar with this category because I invented it.) For a fee, you are able to have both upside potential and downside protection.

Another product called an income-protected account offers some of the same benefits as the variable annuity but with fewer fees and more transparency. An important difference is that it doesn’t bring the guarantee of the insurance company, so it does carry some risk.

Life or Actuarial Risks

Besides investment risks and taxes, you need to consider the life risks of longevity and health, particularly the need for care late in life.

Investments don’t know your state of health, your family history, your potential for longevity or for a caregiver. That’s where insurance should be considered.

Long-term care insurance can pay for three to six years of care at a nursing facility, whereas income annuities ensure lifetime payments no matter the state of your health.

Longevity insurance can address the life risk of outliving your money. It can be purchased on a standalone basis or as part of an income annuity. Investors don’t have to become an actuary to plan for their own lifespan.

As we stated in Part I, there are a whole new set of terms when it comes to planning for retirement income.

The important consideration is to be careful about how you allocate your savings in retirement because it can have important short- and long-term impacts on whether you have sufficient spendable, dependable income.

To determine how much income your current savings could provide, go to Go2Income, where you can design a retirement plan for your personal goals.