Retirement risks: How to protect retirement income from inflation and tax risks
Inflation and taxation erode your income at any stage of life. With retirement income, particularly fixed income, the effects are far more significant. Preserving the value of your retirement income is one of retirement's main challenges.
Relying on guaranteed lifetime income is not sufficient; doing so can actually increase the risk of outliving your retirement savings. The good news is that there are a few ways to mitigate the effects of inflation and taxation.
Use immediate annuities
While an immediate annuity is not always the ideal retirement solution, it can help to reduce the tax risk that retirees face. Buying an immediate annuity can reduce estate taxes and income tax. With estate taxes, it can reduce your estate tax liability partially or fully (depending on the threshold). In addition, there is an income tax benefit, since income from immediate annuities is not taxable. Although the income from these financial instruments can expose retirees to inflation risk, some are indexed to market performance. Such annuities can limit inflation risk.
Investing
The best reasons to invest during retirement include accruing real returns and having another source of retirement income. To achieve a real return, retirees cannot afford to be ultra-conservative with their retirement fund. Using growth options, even if they constitute a small percentage of your portfolio is instrumental in reducing inflation risk. From a tax perspective, using income and growth options for income allows retirees to benefit from the lower capital gains tax instead of income tax (in the case of deferred annuities).
Portfolio diversification
Distributing savings and investments across the three main asset classes—cash, income and growth options—is primarily a risk-management strategy. It addresses many challenges of investing and benefits retirees by helping them to find a balance between growth and preservation. As such, portfolio diversification emphasizes balance and prudence. Retirees must guard against over-exposure to market risk for the sake of real returns or increasing inflation risk by entirely avoiding market risk.
Reallocating investments
You can exchange financial instruments within your portfolio, to make a favourable tax claim. Municipal bond swapping is a good example of this tax-reduction strategy. The idea behind bond swapping is that you can sell your bond and buy a similar bond at the same price. However, once you sell the previous held bond at a loss, then you can claim on that loss—even though your portfolio has not changed. For example, if you bought a bond at $100.00, sold it for $60.00 and bought another similar bond for $60.00, you can claim on the loss of $40.00 for the original bond. However, the integrity of your asset allocation remains intact and you can benefit from an increase in the price of the new bond.
Conclusion
Although inflation and taxation are necessary parts of retirement, they are not insurmountable retirement obstacles. With increasing retirement periods, safeguarding the value of your retirement income is increasingly important. Mitigating inflation and tax risk might well be the first step to a comfortable, low-risk retirement.