How to Balance Work Earnings and Other Income in Retirement
The key to success in any long-term plan is to diversify it. When you invest, for example, you want your retirement account portfolio to hold a variety of asset classes, so you're not as affected by wild swings in the stock market.
That same logic also extends to the type of income you get in retirement, although this form of diversification doesn't get nearly as much attention. People often suggest working in retirement to preserve your savings, but that's just one example of how getting income from multiple sources can impact your finances in retirement.
One of the most important distinctions when it comes to funding your retirement is whether you're using income you earn in some way rather than that which you receive passively — that is, without working for it, at least directly.
For many retirees, it's smart to consider a mix of both. Here's why.
What is earned income?
Examples of earned income" include what you get from working for an employer, receiving tips from customers or running your own business. The IRS definition is the income you receive from doing some work for someone else in exchange for money. That description, in turn, generally sets the rules that other government agencies and other entities follow.
Earned income is important during your working years because it's how most of us will fund a good portion of our retirement nest egg. Only earned income can be used to make contributions to a tax-advantaged account like an IRA or a 401(k).
In addition, your future Social Security payments are calculated based on your 35 highest-earning years of employment. If you work less than that, or don't work long enough for your salary to grow, your Social Security retirement benefits may not be as high.
Once you're in retirement, earning extra income can help stretch your savings and invested funds. But earning retirement income can add complexity to your personal finances, especially when it comes to government benefits and taxes, as we discuss below.
What is passive income?
Colloquially speaking, people use the term "passive income" to describe all sorts of financial sources that don't require performing a job to get money. In common parlance, that could include things like withdrawals from retirement savings, government benefits, interest on a savings account, book royalties or annuity payments.
Passive income in retirement is important because it can help support you beyond your ability to earn an income, like when you're too old to work. Passive income also doesn't affect certain retirement benefits as much as earned income might (we'll dig into this more below).
The IRS uses a more restrictive definition of passive income, which is important when calculating retirement income. Passive income activities include any "trade or business activities in which you don't materially participate during the year." Collecting rent from real estate you own is generally included under this umbrella, even if you manage the property yourself. An exception is made if you're a real estate professional.
Note that the IRS doesn't consider interest, dividends or other "portfolio income" from investments as passive income. That matters because portfolio income is sometimes taxed on a capital gains schedule. Capital gains tax rates depend on how long you hold the asset before selling it, in addition to how much profit you earn from the sale and your overall income.
Depending on your income, you'll pay a capital gains tax rate between 0% and 20% if you hold your investments for over a year before selling them. Capital gains you earn after selling an investment you held for less than a year, on the other hand, are taxed at ordinary income tax rates, which can be as high as 37%.
How to balance income types
Planning your income in retirement is akin to putting together the pieces of a puzzle that's unique to your personal finances, and that will change over time. It's important to have a flexible strategy that will allow you to adjust your income streams as you age.
Here are some things to think about as you plan how you will support yourself during your golden years.
Early retirement income can pay off later
Working after you've retired, even if it's just part-time or on an as-needed basis, offers several advantages. Since working gives you earned income (as opposed to passive income from savings), you're allowed to use your earnings to contribute to tax-advantaged retirement savings accounts. If you're over 50, you can even make bonus catch-up contributions if you wish. You might even still have access to a workplace 401(k) plan, which sometimes will offer employer matching.
Aside from the savings boost you get, working in retirement will help your existing savings last longer. Even better, if that income boost may help you delay claiming Social Security benefits until you're as old as 70. That delay allows you to earn a higher monthly rate, so you could set yourself up for higher Social Security payments for life.
Many people file for Social Security once they're first eligible at age 62, but filing this early reduces your benefit by 30%, and permanently. If you can survive on your salary, savings and other income until you reach at least the full retirement age (or FRA, which is 67 for people born in 1960 or later), you'll get higher benefits. And if you wait until age 70, you'll get benefits that are a full 24% higher than you'd get at the FRA, and for the rest of your life.
However, working in retirement can also be taxing on your physical and mental health, particularly if you're working in a strenuous job. That's why it's important to have passive income from investments, annuities or other savings to boost your finances in retirement.
Financial stability, dependable income
Passive income is, by definition, passive. You're not doing anything to earn it. That's helpful when you're no longer able to work. However, passive income from investments is not without risks. Stock market fluctuations can lower the value of your portfolio, for example, and downturns in the real estate market can make it tough to reliably earn rental income.
Some forms of passive income, like annuities, are safer in that they offer guaranteed payments for life. As employers have switched from defined-benefit pensions to defined-contribution retirement accounts like 401(k)s, most Americans today don't have the kind of stability that guaranteed income provides. Social Security serves as a financial cornerstone for millions of older Americans, but it shouldn't be their only source of retirement income.
Social Security calculations
Whether your income is earned or passive can also affect your retirement benefits, sometimes in complex ways.
For instance, working longer can sometimes increase your Social Security benefits, since your payment is calculated based on your 35 highest-earning years. If some of those years happen to be after you reach retirement age, it still counts.
But working can also reduce your benefits in the short term, at least for early retirees. If you've already filed for Social Security benefits but you haven't yet reached the full retirement age of 67, the Social Security Administration will deduct $1 off your benefits for every $1 to $3 you earn.
Once you reach full retirement age, though, this penalty no longer applies. Plus, the program will reimburse you for those lost benefits.
Tax implications
Earned and passive income streams are taxed differently, which affects how much you pay in taxes each year. Earning more money, for example, may bump you up into a higher tax bracket, which partially offsets the financial benefit of that income.
Additionally, under the passive-income umbrella, different investment types have different rules for taxes and distributions. By the time you're in your 70s, the IRS requires you to start drawing down the money held in tax-deferred accounts like traditional IRAs and 401(k)s.
These required minimum distributions (RMDs) begin when you reach age 73 if you were born in 1951 through 1959, or when you reach age 75 if you were born in 1960 or later. RMDs have the potential to bump you into a new income tax bracket, although advance planning can help mitigate the financial hit.
For example, you could make steady, incremental withdrawals from your account over time prior to reaching your RMD age, to reduce the balance in the account (and thus your future tax bill). You could also convert some of the account's funds to be in a Roth account. Although that move would mean paying taxes immediately on the converted funds, it will give you tax-free growth and withdrawals in the future. That could help you once you begin making RMDs.
Retirees could also buy or convert a portion of funds held in a traditional IRA into annuities. This option allows you to delay taking your RMDs until the age of 85, when your income — and your tax rate — should theoretically be lower.
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Reaching the right balance
Figuring out how to blend income streams in retirement can be tricky. Just because working might cause a reduction in benefits doesn't mean it won't help you, for example. If you can still work to augment your income early in your retirement, the financial trade-offs then can lead to bigger benefits down the road.
The best way to figure out what strategy will give you the most financial security is by consulting with a tax professional and a fiduciary financial advisor, such as a certified financial planner. They'll be able to analyze your individual puzzle pieces and help you put assemble a plan in which everything fits neatly into place.
And, just as your needs for other financial products like life insurance change over time, so might the mix of investment types and specific investments that best suit you in retirement. A financial pro can help with those adjustments, too.