Retirement distributions for Federal Agents – The difference between cash flow and taxable income.
Cash Flow & Income: Two Flowers In The Same Garden
In retirement, sometimes you may have taxable income, but not have any real cash flow that hits your pocket. Strategies for retirement distributions for Federal Agents require you to understand the difference. For example, you may have Mutual Funds or ETFs (Exchange-Traded Funds) in a taxable brokerage account. If these investments give off dividends and the dividends are set to automatically reinvest, then you will have taxable income. But you won’t have cash flow. The dividends would be considered income and taxed accordingly. However, since they are reinvested and not hitting your pant’s pocket then you DO NOT have cash flow.
On the contrary, sometimes you may have cash flow, but it’s not recognized as taxable income. For example, you may have municipal bonds in your account. These investments can put money in your pocket and give you a positive cash flow in retirement. The municipal bonds – “munis” – are typically not taxed at the federal level. This means you won’t have any income on which you would pay taxes. The point being that it can work both ways. Thus, in retirement it’s important to know what sources of cash flow you may have. And it’s important to know what sources of income you may have.
Why can this be important when considering how to distribute assets from your retirement accounts?
If you have a lot of cash flow sources overall, then you may not need distributions from your retirement accounts (distributions that could count as income). Or you may need less of a distribution from your retirement accounts than you thought in a particular year.
Example please:
You just retired early from federal service at age 50. For the initial two years in retirement, you plan on living off two sources. Cash and municipal bonds that you’ve squirreled away. You’re also collecting your federal pension and RAS (Retiree Annuity Supplement). All this while you investigate some part-time work as “a pixie dust spreader on the Tilt-A-Whirl” for Year 3 and beyond (be first to email me the movie and I’ll send you a little something: Hello@charlesmichaelfinancial.com).
So to start with, you have two sources of cash flow. Both will provide for your living expenses for retirement Years 1 and 2. These are your pension and your supplement. These will stay consistent and be predictable sources of income, upon which you’ll pay ordinary income taxes.
You will also have two other sources of cash flow. The IRS will not tax these in Years 1 and 2. These are the cash in your bank (you’ve already paid taxes on this money) and the interest income on your municipal bonds (which is tax-free at the federal level). Because you have a strong overall cash flow in Years 1 and 2 (your cash, muni bond interest, pension and RAS), you decide that you don’t need to make any withdrawals from your retirement accounts in Years 1 and 2. Again, withdrawals from your retirement accounts would be taxable income. So if you avoid this then the amount of income you recognize in Years 1 and 2 is much less than the average bear.
Roth Conversions Perhaps?
Knowing you have a strong cash flow is great for planning purposes. It means you may then wish to pull out other “tools from your toolbox” (thank you FLETC for never letting this phrase leave my brain no matter how hard I try). For instance, this means that those first years of retirement, when you aren’t working, could be a good time to consider Roth conversions from your Traditional Thrift Savings Plan (TSP).
Now of course, this is a simplified scenario. And yes, you’ll always have at least your federal pension in retirement so your tax bracket could likely be higher than someone who of course doesn’t have a pension. But the analysis of a Roth conversion will still come into play. Remember, the point of the Roth conversion is simply to pay taxes when rates are lowest. So even if your pension puts you in a 22% tax bracket for a very long time, a conversion may still be a win for you if you’d otherwise pay something more than 22% later down the road.
Roth conversions are a topic for another day. The point here is that understanding your cash flow sources can help you to better understand your tax profile. This makes the strategies for retirement distributions for Federal Agents easier to implement.
Examples of Taxable Income
- Earnings & Wages (e.g., you are working full/part-time in retirement)
- Ownership in a business
- Liquidity events before and during retirement (e.g., sale of a business)
- Rental income
- Social Security
- Pension
- Non-qualified annuities (that may generate taxable income)
- Inheritances: Types and Timing (e.g., an IRA may need to be distributed over 10 years, while a brokerage account may kick off income in the form of interest and dividends that need to be accounted for)
All of the above are examples of the sources of income that you need to be mindful of as you walk toward an early, or regular, retirement. Some of the sources are more easily predictable, such as social security. Yes, some nuances will emerge depending on when it’s taken, but the amount is still fairly predictable. On the other hand, some sources of income in retirement can be harder to predict. For example, let’s say you are walking toward an early retirement from the government – again at age 50. You’ve recently started your own business. You think that you will eventually sell it for a profit in 12 years. Well, there is a lot that can happen in 12 years. This includes a change in your desire to be a business owner. Thus, this type of income source would fall into the less predictable side of the equation.
Knowing your possible sources of income in retirement and their associated level of predictability can also be very helpful in crafting your tax profile. In turn, understanding how your tax profile is shaping up as you close in on or enter retirement is key. It will help you get a handle on how much and from which accounts you may need to make distributions from in retirement.
Remember your personal financial situation is just that, very personal. And your financial plan should reflect what works best for you. Don’t run out and make any moves until you weigh all the pros and cons and/or speak to a financial professional. Either way, you’re a leader in your family. Continue to educate yourself and position yourself to win with money.
Be the Hero for You and Yours!
