Cash Flow vs Income in Retirement: Avoid Overpaying Taxes
Ask a retiree how much income they need, and they’ll give you a number. Ask how much cash flow their portfolio generates, and many will give you the same number. Ask what they actually spend, and you’ll often get a third answer — or a shrug.
That’s the problem. These are three different things, and mixing them up can quietly cost money. Here’s a breakdown.
Cash flow is the movement of money, regardless of tax implications.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
Move money from savings to checking? Cash flow, but no tax.
Take a qualified withdrawal from your IRA? Cash flow with a tax implication.
Sell $50,000 of stock you bought for $40,000? That’s $50,000 of cash flow, but only the $10,000 gain is taxed.
Harvest a loss on a position that’s down? That’s cash flow, too, and it can actually lower your tax bill.
Much of what moves through your accounts is simply your own money changing seats.
Income is what gets taxed (and it comes with a decision). Income shows up on your tax return:
- Dividends paid
- Interest earned
- Rent collected
- Capital gains realized
- IRA withdrawals taken
Here’s the part many people miss: Income comes with a decision. You can spend the money or reinvest it.
Depending on the account, your decisions are taxed differently. For example, in a brokerage account, the dividend (income) is taxed whether you spend it or not. If the dividend comes into your qualified account (IRA or Roth), it’s not taxed.
It’s important to pay attention to these little differences.
Spending is what’s gone. This is the money that leaves your accounts to support you and your lifestyle (groceries, travel, property taxes). Once it’s spent, it’s gone. It isn’t coming back as shares, basis or anything else.
Spending is the number your plan actually has to cover. Not your cash flow. Not your income. Your spending.
The drag many miss
Once the terms are straight and the plan is in place, the leaks start to become visible. Many retirees generate more taxable income than they spend.
A $1 million portfolio in your brokerage account, yielding 3% in dividends, puts about $30,000 of income on your tax return each year, whether you spend it or reinvest it.
Let’s say you spend only $10,000 of it — you still pay tax on all $30,000. You wrote the IRS a check for the privilege of reinvesting money you’d already had invested. Do that for a decade, and the drag compounds quietly, every April.
Even withdrawal coordination can make a big difference. A retiree younger than 65 who funds an entire year from long-term capital gains might pay mostly 0% in capital gains tax. That’s because only the realized gains count as income.
If they keep their gains/income low enough, they may also be able to lower their ACA health insurance premiums. That’s a very different situation than taking a little from an IRA, a little from a brokerage account, collecting dividends along the way and layering on Roth conversions.
Same spending, very different tax bill.
Total return still wins
This is why I push retirees toward “total return” thinking. There’s little difference between a stock that grows by 7% and a stock that grows by 4% while paying a 3% dividend.
The grower lets you decide when to realize income. The dividend payer decides for you, every quarter, whether you need the money or not.
Sometimes growth may be better than dividends, and vice versa.
The same is true in real estate: Rent plus appreciation is the whole picture, and the rent is taxed as it arrives.
Control what you can control
Dividend investing is a great way to grow a portfolio or generate income you can spend in retirement. The main problem is that you can’t control what a company pays out.
When a dividend stops paying out, the stock may also go down in value, which can feel similar to a stock you have purchased for growth that stopped growing. The market (stocks, bonds, real estate) carries risk, no matter how you look at it.
What you can control is how much you spend from your accounts. In other words, grow your money however you see best, whether it’s through growth, dividends or real estate. That’s up to you.
Next, separate the growth or payout rate from how much you want to spend.
Lastly, make sure you have a backup plan so you can maintain your lifestyle and spending, regardless of market conditions.
In my book, How to Retire on Time, I call that your Reserves. Other advisers have other names for it.
The bottom line: Don’t let someone else’s decision (dividend payout, etc.) control your retirement, and make sure you are watching your cash flow, your income and your spending so they all work together efficiently.
