Managing Cash Flow In Retirement

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While you’re working, your primary financial focus is on saving and growing your money. But, that changes once you declare Financial Independence. From then on the name of the game is cash flow management.In simple terms, cash flow is what’s left of your income once your expenses are paid. My definition of Financial Independence is, “Being able to live the lifestyle you choose for the rest of your life without having to work for the money to do so.” Given this context, your expenses would be all the things you need to pay for each month to “live the lifestyle you choose.”

But, cash flow needs to cover more than just your expenses. You’ll also need to save additional money for emergencies and large purchases such as a new car. Many times as you work toward Financial Independence you’ll change your estimate as to how much income you’ll need when you retire. That doesn’t mean you shouldn’t plan. You should always have a plan for your Financial Independence. When your goals change, adjust your financial plan accordingly and continue moving forward.

There are only two elements in cash flow–income and expenses. Both are equally important in managing a healthy cash flow. From the time you start saving for Financial Independence you should begin planning ways to optimize both.

Cash Flow – Expenses

While the focus of this blog is certainly on providing income for your Financial Independence, you need to have a good understanding of how expenses will play in your plan.

Surprisingly, the expenses side of the cash flow ledger has a more direct influence on your cash flow. When you earn income, it usually doesn’t alladd to your cash flow. Often, part of it is withheld for taxes or other deductions. Expenses are different. In almost every case, when you reduce your expenses your cash flow is increased by that amount. If you decide to “cut the cord” and get rid of cable you may reduce your expenses by $100 a month. Your cash flow is immediately increased by the entire $100.

Managing Housing Expenses

The largest expense most people will ever have is their mortgage or rent. Imagine how much farther your income would go each month if you didn’t have to pay for housing! Don’t forget, you’d still need to budget for, and pay, property taxes and homeowners insurance. But, your cash flow will substantially increase if you don’t have to make the principle and interest payments. It could free up as much as $1,000 – $2,000 each month that you can use for other things.

Paying off a mortgage is no small task! Years (maybe even decades) in advance of declaring Financial Independence you should formulate a plan for how you’ll be mortgage-free by the time you want to declare Financial Independence. Your plan may involve any one, or a combination, of the following strategies:

  1. Plan to pay off your mortgage by making regular payments with a payoff date of just before you want to declare Financial Independence.
  2. Accelerate your mortgage payoff by increasing your principle payment each month. Just an extra $100 each month will allow you to pay off your mortgage years earlier, and save tens or even hundreds of thousands of dollars in interest.
  3. Budget extra money in your IRA / 401(k) to pay off the mortgage before you declare Financial Independence. To avoid a huge tax bill, plan on paying off your mortgage with money from a Roth IRA. Remember, you won’t have to pay income taxes on money taken from a Roth IRA. But, taking $150,000 out of your traditional IRA to pay off your mortgage will hit you with a one-time tax bill of tens of thousands of dollars.
  4. Plan on downsizing. Now that the kids have moved out, sell your larger house and move into a smaller less expensive place. Use equity that you’ve built in your larger house to completely pay for the smaller one.

Beside your housing costs, other big expenses are medical, utilities (electric, gas and water), and insurance. Plan for ways to manage these expenses in addition to your mortgage heading into Financial Independence. Remember that, in most cases, each dollar you save in expenses adds an equal amount to your cash flow. When you enter Financial Independence with your expenses under control you’ll be way ahead with your cash flow. But, there are only so many expenses that you can reduce. You’ll still need income.

Cash Flow – Income

When you read this blog I can see where you might think that I’m advocating that all your income come from your investments. Not so! Throughout your working career you should explore a few ways to generate passive income for when you no longer work at a regular job.

When you retire and declare Financial Independence with various other sources of additional income you’ll be less reliant on your savings for your cash flow. That means you’ll either be able to declare Financial Independence sooner. Or, you’ll be able to declare Financial Independence with more money—allowing you to do more.

How Your Savings Provides Income

Some people believe that once you declare Financial Independence you get to start spending your savings and using it to live on the rest or your life. I have a different view on that. I plan on living a long life and I don’t want to chance running out of money before I die.

Instead of spending your savings, use part of the annual growth it produces as your annual income. Think of your savings as a goose that lays golden eggs. Each year it lays a golden egg in the form of growth. Use that golden egg as your annual income. You’ll get golden eggs for as long as you live if you take good care of the goose.

In my examples in prior posts I’ve used 8% as an estimated average growth rate. If you had $1 million in savings, 8% growth would give you an average of $80,000 a year and you’d never spend any of the original $1 million. However, you’ll need to grow your savings a little each year to account for inflation. To do so you’ll need your savings to supply your cash flow income and still be able grow a bit.

How Much of Your Income Will Come From Savings?

The amount of money you need to have in savings, and thus, how much annual income it needs to produce, will depend on the standard of living you desire and what percentage of your income needs to come from growth of your savings.

For example, let’s say that you’ve planned you need $75,000 a year to be Financially Independent. If you needed your savings to supply 100% of that income, a rough, back-of-the-napkin calculation would mean you’d need about $1.5 million in savings. At 8% growth your investments would earn an average of $120,000 per year. You’d use $75,000 of that for your income leaving $45,000 to grow your savings. To account for inflation, you’ll need to grow your savings a bit to provide the same buying power in later years.

If, however, you had other sources of income totaling $35,000, you’d only need your savings to provide the remaining $40,000. Your savings would only need to be $800,000 (instead of $1.5 million) to provide that while still giving you the same amount of growth each year.

Sources of Passive Income

Since my definition of Financial Independence includes the phrase, “without having to work for it,” you’ll want to develop “passive income.” While this may still mean “work,” it’ll be work on your terms and not working for someone else.

Here are some examples of passive income:

  • Rental income from houses, apartments or commercial buildings. During your working career, you may have opportunities to purchase real estate that you can fix up and then rent. Even if you decide to sell your properties you may be able to provide financing to the buyer. Those payments will provide you with years of additional income. Plus, you’d make more money through the finance charges to the buyer!
  • Royalties from books or music that you’ve written and published. Even simple, self-published books on Amazon can earn monthly royalty checks for years.
  • Income from your hobbies. As you become expert in your hobby or interest you may find that people will pay for your products, services, or knowledge of the subject. Sell items online or try starting a newsletter or blog.
  • Social Security. Social Security may not be around when you’re ready to declare Financial Independence, but you never know. This has been a very difficult issue for Congress to address. It bears keeping an eye on over the next few years. It could still play some role in your retirement.
  • Pensions. As with Social Security, pensions are on their way out. Companies are finding that they’re very expensive to maintain and fewer and fewer companies offer one. Your best bet for a pension now is by working at some level in government, but even they are finding it difficult to fund them.

Of course there are many other ways of making extra money. When you generate multiple sources of passive income you remove the pressure of needing a big number in your savings to generate all the income you need.

Why is This Important to You?

If you understand how important cash flow is for Financial Independence, you can start planning for it early. Some plans take years to come to fruition, so start thinking now about what it’ll take to have a fantastic cash flow.

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