Why You Should Solve for Retirement Cashflow, Not Income

Income, cashflow and withdrawals are not the same thing.

cash flow label on hanging file
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The word “income” gets me in trouble when I am talking with people about their retirement. It gets me in trouble because when I say income people assume I mean money from a job they have, Social Security benefits they receive, pension income, or interest and dividends from investments they own.

This definition of income tends to match what would show up on your tax return as income. However, this definition of income doesn’t always work for retirement planning.

What you need in retirement is cashflow. Each month you have expenses, and you need cash coming in to meet those expenses. Depending on how you plan for retirement, that cashflow might come from many different places, and not all of it will fit the technical definition of income.

Let’s take a look at how retirement cashflow is different than income.

Cashflow versus Income

Let's say you estimate you will need to buy a car about every 10 years in retirement. At retirement, you buy a CD or a bond that will mature in 10 years to fund your next car purchase. When it matures you plan to spend both the principal and interest to purchase the car. You will have the cashflow you need to buy the car, but when the CD or bond matures it will not be reported as income on your tax return.

Instead, you will report the interest the CD earned as income on your tax return each year along the way - even though you let the interest accumulate. In retirement, you want to plan out your cashflow needs and choose investments that have an appropriate risk level to match those needs. 

The amount of income you report on your tax return may be quite different than your annual cash flow needs. For example, in early retirement, you may report less income on your tax return, and in later retirement, you may report more income - yet your cash flow could remain the same. How could this be?

Suppose you retire at 65, but you make a plan and start Social Security at age 70. To meet your cashflow needs from 65 to 70 you buy an immediate annuity with a five-year payout and you buy it with non-retirement money. The monthly annuity payment you receive will provide cashflow, as each payment you receive is a combination of principal and interest; but only the interest portion is considered taxable income on your tax return, so in this situation, you have more cashflow than income.

Now fast forward seven years. At age 70 ½ you are required to take annual distributions from your retirement accounts. These withdrawals are reported as taxable income on your tax return. Each year you get older you must withdraw a larger proportion of your remaining retirement account. You may not need to spend it all. In this case, you have more income than your cashflow needs require.

Does the Terminology Matter?

Unless you have a lot of money relative to the amount of cashflow you will need in retirement, it is unlikely you will be able to live off your income; instead it is likely you will need to use some of your principal by following a plan that allows you to use it at a measured pace so you have a comfortable retirement lifestyle, while at the same time not running the risk of running out of money. This kind of planning solves for the amount of cashflow you will need.

Now you know why retirement planners don't spend much time discussing with you the rate of return you can plan to see with your retirement accounts. Instead, they talk to you about how much you can draw from the account each month. Ideally, you will have investments that continue to earn a reasonably impressive return but plan to draw on accounts more than you earn.