What is retirement income?

Retirement income is the income received by the retiring person after retirement. Income can either be paid every month or paid annually. The retiree would get a guaranteed income until their death. Retirement income payment differs from person to person based on their investment type and payment method. Some are paid on a lump-sum basis and some are paid in a regular series with fixed payment or variable cash flow. Retirement income can be created from retirement savings, investment, salary, bonus, and wages from employment. Every working individual should plan their retirement income according to their income goals for the future. The plan should be made by identifying suitable income sources, estimating future expenses, applying a savings plan, and managing risk and assets. The most common age for retirement is between 60-65 years.  

Sources of retirement income

A retiree has different income sources to accumulate and build retirement income. The following are the common source of retirement income that can be used:

Social security

Social security is an insurance program that covers the replacement income of retirees after retirement. The payment will be paid to a qualified retired person, disabled person, and their dependent family members. This program is called Old-Age, Survivors, and Disability Insurance (OASDI) and it is run by Social Security Administration. During the working years of a person, he/she will make payment to the social security program through payroll withholdings. The eligibility criteria to claim social security is that the person has to make a contribution for at least 10 years. A monthly payment will be paid after full retirement or early retirement. The benefits of social security are calculated on the basis of a person’s average monthly earnings for their 35 highest-earning years. A person has to earn 40 credits to claim the benefits. Here the benefits are subjected to tax according to their income and status of tax filing.

Distribution from the retirement account

A person who earns income can open a retirement account which is too similar to a savings account that offers some tax benefits. A person can save some amount for long-term investment to earn retirement income in the future.  There are different types of retirement accounts like an individual retirement account (IRA), Roth IRA, simplified employee pension, savings-investment match plan for employees IRA, etc. According to the retirement account, distribution also differs from each account. A separate guideline is followed for distribution purposes. In most plans, a minimum amount must be withdrawn from the retirement account when the person reaches the age for distribution. These distributions are taxable as income.

Taxable investment account

A taxable investment account is one of the best options for retirement income. Achieving future financial goals after retirement would be difficult if investments were not made at present. A taxable investment account helps in buying and selling bonds, stocks, index funds, and exchange-traded funds. Here any increase in the income or receiving dividend will be applicable to tax for the particular financial year. The tax rate would be charged for gains as that of nominal income or at lower long-term capital gains. It gives access to several investment options that are present in the market and follow different strategies to hold the investment to earn income. There is no age restriction for opening or closing the investment account so investors can access a variety of investments with help from investment brokers and financial advisors.

Pension

In a pension plan, an employer and employee make a regular contribution in a specified percentage to a pool of money that benefits the employee after retirement. There are two types of pension plans that are used by people who have defined benefit plans and defined contribution plans. In a defined benefit plan the retiree would get a specified amount on a monthly basis for a lifetime after retirement or a lump sum amount is distributed. Some plan allows the retiree to get part of the amount in a lump sum and the remaining amount on a monthly basis. In a defined contribution plan, it does not pay a specified amount instead amount will be paid as per the performance of the chosen investment plan that grows during the years of a working employee. The pension plans often come with a tax advantage for both the employer and employee.

401(k)

It is one of the retirement savings plans where the employer and employee will make financial contributions. The employee will contribute a certain percentage of his monthly income directly into an investment account. In a traditional 401(k) plan, the employee contribution is made before the income tax deduction. So the contribution can be shown as a tax deduction for the year. No tax is imposed on the contribution or income until the employee withdraws the money or until retirement.

Roth 401(k)

According to this plan, the contribution is made after deducting the tax from the paycheck. Thus, there will be no additional taxes imposed at the time of withdrawal during retirement.

Types of Individual retirement account

The following are the types are individual retirement account:

Individual Retirement Account (IRA)

IRA can be opened only by the earning people. Here, the amount contributed to IRA will not be taxable. The amount will be considered as a taxable income when it is withdrawn from the account.

Roth IRA

In Roth IRA, a person who earns income will be eligible for opening an account. The contributing amount should not be more than the earned income. The contributed amount is subjected to tax in Roth IRA. No tax will be charged while withdrawing money from the account.

Simplified employee pension IRA

A simplified employee pension IRA is created especially for owners of small business who has more employees and also for self-employed individuals. The account holder has to keep 25% of compensation or $58,000 whichever is less. The contribution amount to the account is free from tax, but withdrawals are considered as taxable income.

Context and Applications

The above-discussed content can be used for preparing exams for undergraduate and postgraduate courses like,

• Bachelors of Business Administration (Finance)
• Bachelors of Professional Accountancy
• Masters of Business Administration (Finance)
• Masters of Professional Accountancy

Practice Problems

Question 1: After the working life of an employee income earned from other sources is called ________.

1) Retirement income

2) Capital gain

3) Tax

Answer: Option 1 is correct.

Explanation: Retirement income is earned after the end of the work-life of an employee. The normal age of retirement lies between 60 to 70. Usually, an employee would plan their retirement income from sources like pension plans, investment accounts, and retirement account, etc.

Question 2: From the following, choose the correct retirement plan.

1) Income tax

2) Social security program

3) Loan from banks

Answer: Option 2 is correct.

Explanation: Social security plan is one of the retirement incomes sources. It is one of the commonly used retirement plans. A certain amount is saved by the insurer for future use while retirement or disability to work. Here payment is given to retirees, disabled persons, or their spouses, children, and survivors.  

Question 3: In pension plans, _______ plan retire would get a specified amount in monthly basis and in __________ plan retire would not get a specified amount.

1) Real estate, saving bank account

2) Defined contribution plan, defined benefit plan

3) Defined benefit plan, defined contribution plan

Answer: Option 3 is correct.

Explanation: Pension plans have two types. In a defined benefit plan, specified money will be paid after retirement on a monthly basis until the death of a retire. But in defined contribution, no specified amount will be paid to the retiree. The money will be paid only based on the performance of the investment chosen by the person.

Question 4: OASDI stands for _________.

1) Olden age, special disability insurance

2) Old age, survivors, and disability insurance

3) Old people survivor disability income

Answer: Option 2 is correct.

Explanation: OASDI stands for old age, survivors, and insurance program. It replaces the income that is lost due to old age, death of life-partner, and any disability. It is a social security program run by the federal. The money is paid to beneficiaries in terms of earnings made during the work year.

Question 5: In individual retirement account withdrawn amount is __________.

1) Added to contribution.

2) Not taxable

3) Taxable

Answer: Option 3 is correct.

Explanation: Individual retirement account allows a person to save money for retirement. The contribution that is made by the employee for his own retirement. It reduces the tax for contribution and investment grows until the retiree withdraws from the account. The investment that yields earnings is subjected to deferred tax or lower tax. The amount withdrawn from the account is considered as taxable income.