When I work with pilots to create a retirement income stream, I liken it to mountain climbing. If you ask most people what the goal of mountain climbing is, they often say “to get to the top.” The real goal is to not only make the climb up, but to get back down the mountain safely. In fact, more accidents occur during the descent phase then during the ascent.
This is also true for retirement planning. Most people when planning for retirement are focused on the accumulation phase, or building their retirement balance. They lose sight of the real goal which is creating a portfolio that can deliver a lifetime income stream during retirement. In my experience, pilots typically excel in the accumulation phase of retirement. Converting those savings to a target amount of income for their lifetime is more difficult.
Pay Check vs. “Play Check”1
The first step in designing retirement income is determining the difference between a pay check and “play check.” A pay check does what the name says, pays basic living expenses, housing, food, healthcare and any necessities. For pilots, the pay check typically comes from a pension amount and social security. If that amount is not sufficient to meet lifestyle needs, we may suggest tapping the fixed income portion of savings or buying an annuity to increase the amount of the pay check. This is used to cover all your fixed costs.
After your pay check is covered, my recommendation is to then invest the remainder of your retirement savings balance for inflation protection and to use it to create the “play check.” Take the retirement savings balance, typically in an IRA, and create a diversified investment program. Use your IRA investments (stocks, bonds and cash) to fund your “play check” to generate income above and beyond basic needs.
Key Ingredients of a Pilot's Retirement Pay Check: Planning and Patience are Rewarded
Waiting to tap your pension, if possible, will reward you for your patience and planning. For example, a United pilot may begin PBGC payments at age 60, even if not yet retired. However, for every year you wait to take your pension payment, the amount you receive increases by 10‐12% per year. By age 70, this results in a 160% increase in your annual benefit.
The same is true for Social Security as patience and planning are also rewarded by the government. Many individuals take Social Security when they become eligible at age 62. Like your pension, Social Security provides a hedge against longevity risk—the longer you defer, the bigger your benefit. If you wait until age 70, you may receive as much as 32% more income. A frequent question I get from many pilots is, “What retirement sources should I tap first to optimize withdrawals and make the best choices to generate retirement income?”
Tax Brackets & Marginal Tax Brackets
Key to Withdrawal Success Many experts recommend withdrawing from your taxable savings accounts first, since these are subject to capital gains, but not income tax. The rationale here is that you will pay capital gains taxes on these withdrawals, about 15% for most people, versus the ordinary‐income tax rates (10% – 37%) you would pay on IRA withdrawals.
In retirement, taxes are important. During your working years, you have a salary and can't control what tax bracket you fall in. However, when you are planning for retirement income, you may have more control and you want to pay more attention to tax brackets and marginal tax brackets. Withdrawals from your various savings accounts can be taxed at very different rates. You need to understand your different sources of savings, whether they are taxable, tax‐free or tax‐deferred and how they will be treated. When you are retired, adding additional income can push you into a different marginal tax bracket.
Pilots have multiple sources of retirement income and savings, some you can control and some you can't. Your pension is set along with Social Security. You will be subject to some tax on these sources. A significant break point in income taxation is moving from a 12% tax bracket to a 22% tax bracket which occurs around an income level of about $77,400 a year (married filing joint). This is an income threshold some pilots find themselves approaching between pension and social security payments. Many of the pilots we work with seek an annual income above this amount. They may make up the difference by taking a taxable withdrawal from their IRA, which is typically their largest source of retirement savings. However, if that withdrawal pushes you into a new tax bracket, it can create an expensive and unwanted tax burden.
We encourage pilots to tap sources that won't change their tax bracket. Tapping a Roth account or brokerage account for that same withdrawal amount may be more effective than tapping your IRA because the tax consequences are less.
However, I caution pilots to be careful in “burning off” too much of their assets in their taxable accounts that are only subject to 15% capital gains taxes versus ordinary income taxes. Overall, I advocate for a tax strategy that allows diversification in income generation as well. As I mentioned, many experts and planning tools will recommend using taxable money first as part of a retirement income withdrawal strategy. In my experience, oversight here is beneficial. The concept of using ordinary taxable income sources first up to the highest level of the lower marginal tax brackets and then tapping your more “tax friendly” accounts for any additional needed income may be a very sound strategy. By working with tax and financial advisors who can understand the nuances of tax diversification strategies, you can make decisions that maximize your retirement income and also create the best tax outcomes.
Additional Retirement Saving Tips & Tricks
Use a Tax Diversification Strategy
While Saving One approach that is effective under the right circumstances is to employ a tax diversification strategy while accumulating your savings. For example, if you are 50, you can put your 401(k) retirement savings ($18,500 annually, or $24,500 with the catch‐up contribution) into a Roth option. Many people chose a traditional 401k to get the immediate tax benefit of the deduction. But modeling indicates that by implementing tax diversification ahead of time and saving in a Roth, you will create savings withdrawals that are tax‐free later instead of all taxable withdrawals giving yourself more options.
Convert Savings to Roth
Another interesting tax diversification approach is to choose to retire at a certain point in a year to minimize taxable income. For example, a pilot who retires early in a taxable year and ends up in a lower tax bracket can convert a portion of pre‐tax savings in an IRA to a Roth account with lower tax consequences. These tax diversification strategies can be very beneficial in the long run.
Remember, at 70 1/2 the government mandates you take minimum distributions from IRAs and retirement plans which will change the amount of income you need to take out. We work closely with our clients as they transition to taking required distributions to make sure they are still making the best withdrawal decisions with the optimal tax consequences.
1 From “Paychecks and Playchecks – Retirement Solutions for Life” by Tom Hegna
ABOUT THE AUTHOR
Managing Director, The Pilot Program | Johnson Financial Group
Robert Warner is Managing Director, The Pilot Program, Johnson Financial Group and EVP Johnson Wealth, a Johnson Financial Group Company. He is also a Chartered Financial Consultant (ChFC®). He has over 25 years experience helping clients, including active pilots and their families achieve their retirement and estate planning goals with an emphasis on estate conservation and wealth transfer planning.