401(k), Pension or Social Security — Which Should You Take First?

If you're approaching retirement and you're fortunate enough to have a 401k, a pension, and social security, then I've got a question for you. Which one are you supposed to take first? Because the answer is probably not as obvious as you think. Your pension affects your taxes. Your 401k withdrawals affect your social security taxation. Your social security decision affects your spouse. Roth conversions can affect your Medicare premiums. And the money you refuse to take out of your IRA today may eventually become money the government requires you to take out later. So the question isn't, should I take my pension? Should I claim social security? Should I withdraw from my 401k? The better question is, which order should I turn these things on so that they work together? There is no universal answer to where the 401k is always first, the pension is always second, and the social security benefits are always third. The strategy is figuring out which dollar should do which job and when. Now let's start with something critical. If you have a pension, social security, and a meaningful 401k or IRA, you're in a pretty unique position. In fact, I think 20% of all Americans have a pension and the vast majority of those are government workers. So because you own three different types of retirement dollars, you have a pension that can provide predictable income. Social security is the cheapest inflation-adjusted lifetime income annuity that you can get. And then your 401k, it gives you something that neither of those other two do, which is control. So think about three employees. One is extremely reliable but only works a fixed schedule. Another gets a raise the longer you wait to hire him. And the third says, hey Cody, tell me when you need me and how much work you want me to do. That's your 401k. Now ironically, the account retirees are often most afraid to touch. It may be the account that gives them the greatest planning flexibility because once a pension starts, generally that decision is difficult or even impossible to undo. Once you claim social security, you've made a major claiming decision, you can go back on it, but there are challenges to that. Your IRA, you might take $40,000 this year, $80,000 next year, maybe you do a Roth conversion the following year. Take very little the year after that. You know, that flexibility is extraordinarily valuable. And this brings us to what I call the golden window. So let's imagine Mike and Susan. Mike owns a business and retires at 62, Susan is 60, they've accumulated 1.8 million between their 401ks and IRAs, another 350 grand in taxable investments and cash. Mike has a pension available and eventually they'll both receive social security. So they've done a great job. But when Mike retires, something unusual happens. For the first time in probably 40 years, their taxable income falls off a cliff, right? They have no salary, no business income, no social security yet, maybe no pension yet, and required minimum distributions haven't started. So most retirees look at that and they think, hey, this is fantastic. We barely have any income, we're gonna pay almost nothing in taxes. Now, I look at that a little bit differently. I see an empty tax bracket. And an empty tax bracket can be an asset. Because this may be the lowest tax period Mike and Susan experience for the rest of their lives. Once social security starts, some of that will become taxable. Once the pension starts, that generally is taxable income, and eventually RMDs arrive. Oh, and if one spouse dies, now the survivor may have much of the same income and many of the same assets, but potentially files as a single taxpayer. That's why I don't automatically want Mike and Susan sitting there at 62 saying, hey, don't touch the IRA. I may want to do the opposite. Now, this could be the time to deliberately take money out. Maybe some of it funds their lifestyle. Maybe some gets converted to a Roth. Maybe we're harvesting long-term capital gains in their taxable account while that income is lower. The point isn't to minimize this year's tax bill. That is one of the biggest mistakes that I see in retirement tax planning. The goal isn't to pay the least tax this year. The goal is to manage the tax bill over retirement. Now, those are very different objectives. Here's another way to think about that. Imagine a farmer who refuses to harvest any crops because they don't want to pay tax on the harvest. Every year, he says, hey, we're going to leave it in the field, so they do. The field gets bigger, the crop gets bigger, and eventually the government shows up and says, all right, you've waited long enough. Time to start harvesting. Now, that's essentially what can happen with a large pre-tax retirement account. You've received the tax deduction on the way in. The money grew tax deferred, but the IRS did not forget about it. And at some point, required minimum distributions can begin forcing that taxable money out whether you need it or not. So there are retirees for whom spending IRA money early isn't a failure of the retirement plan. It's part of that plan. It's a major distinction. Now, there is another side to this. I see people online say, hey, just convert all the way up to the top of the 22 or the 24% bracket. I don't like these catch-all rules because your tax bracket isn't the only line we're watching. A Roth conversion can increase modified adjusted gross income, which can then affect Medicare IRMA premiums. It can affect the taxation of Social Security. And if you're retiring before Medicare and buying health insurance through the marketplace, then income can potentially affect premium tax credits. And under current law, there's also this enhanced senior deduction available to qualifying taxpayers age 65 and older that will phase out as income rises. So I don't wanna fill a tax bracket just because there's room in it. I wanna understand what happens to the rest of the plan when I put together another dollar on the income tax return. And this is why I tell people, your marginal tax rate and your marginal cost are not always the same thing. Now, let's talk about the pension. Pensions are interesting because people tend to fall into one of two camps, right? Camp one says, I've earned it, let's turn it on. Camp two says, hey, give me the lump sum because I want control. Neither answer is automatically correct. First, we have to understand what it is we're actually being offered. If the pension is 5,000 per month at 65, but 6,000 per month if we wait, then we need to assess what's the economic value of waiting. What are we giving up in the meantime? Does the pension have a cost of living adjustment? What happens when you die? Is it single life, 50% survivor, 75%? Or are we looking at a 100% joint and survivor annuity? This isn't simply an income decision, especially for a married couple, it's potentially a survivor income decision. So let's suppose Mike's pension is 60 grand per year under the single life option, but significantly less with that full survivor benefit. So Mike looks at Susan and says, why would we take less money every month? I'm healthy. Well, that's exactly when I want to slow the conversation down because we're not designing the plan only for years when both of them are sitting at the kitchen table. We're also designing the plan for the day when one of those chairs is empty. Now that sounds grim, but good retirement planning has to account for it because if Mike passes first, which income disappears? Does the pension disappear? Does one social security check, which is significant, disappear? What happens to the survivor's tax filing status? How much income does Susan actually have left? A pension election shouldn't be made by looking at the biggest number on the benefit statement. It should be made by looking at the household. Now, let's get to social security. This is where I see another common mistake. So someone pulls out a calculator and says, if I take social security at 62, I'll receive X dollars. If I wait until 70, I'll receive Y. I have to live until 81 for waiting to pay off. Okay, that's useful information, but I don't think it's the entire decision, right? For somebody born in 1960 or later, your full retirement age is 67. If that person waits beyond full retirement age, delayed retirement credits increase the worker's benefit by about 8% until they're 70. Everybody knows that. But that doesn't mean delaying is always better. If you're single with serious longevity concerns, well, then the analysis is gonna look a lot different. If you need the income, it can look different. If claiming allows you to avoid liquidating investments during a major market decline, that's pretty critical. But for married couples, there's another person in this equation, the surviving spouse. If Mike is the higher social security earner and he passes first, Susan generally doesn't continue receiving both checks. Remember, the household transitions to the applicable survivor benefit. That means Mike delaying his higher benefit may not simply be about Mike collecting more money. It can also increase the income attached to the higher benefit that may ultimately protect Susan. So when someone tells me, I wanna claim at 62 because I don't know how long I'm going to live. One of my questions is, okay, but how long might your spouse live? It's a completely different conversation. So let's pull all of this together. Let's go back to Mike and Susan. Mike retires at 62 and instead of immediately turning everything on, imagine we build a runway. For the first several years, the paycheck is gone. So we intentionally use some cash and taxable assets. We strategically distribute money from the IRA. Some of that IRA money pays the bills. Some years we may convert additional dollars into the Roth. We are watching their tax brackets. We are watching Medicare. We're watching their investment portfolio and we're watching future RMDs. Then at the appropriate point, the pension turns on. So now we've created another layer of that dependable income and perhaps that income allows Mike, the higher social security earner, to delay social security further. Eventually, social security turns on. Now look what we've done. We didn't simply delay income. We used the years when Mike and Susan had the most flexibility to reposition their balance sheet before the years when they had less flexibility. So that is the strategy. And I wanna emphasize something. I'm not telling you that this exact sequence is what you should do. Sometimes I absolutely want to take social security earlier and sometimes I want the pension immediately. Sometimes I don't wanna do any Roth conversions at all. Sometimes I wanna leave a substantial IRA balance late into retirement. That's why rules of thumb frustrate me. Retirement planning is not paint by numbers. Think about your retirement like an aircraft carrier. At 35, if you're pointed a few degrees in the wrong direction, it doesn't seem like a big deal. You've got decades to correct it. But in retirement, some decisions become significantly difficult to reverse. Pension elections and social security claiming decisions, large Roth conversions, how much guaranteed income you build, how much market risk you carry when withdrawals begin. These are not decisions I wanna make five minutes before we need them. I want to turn the ship while we still have room. That's why obviously the best time to start this process isn't five days before you retire, it's three to five years before you retire. Because then we can see the runway. When I'm building this for a family, I'm essentially trying to answer those type of questions. So 401k, pension, social security, which one should you take first? Hopefully by now you realize that's almost always the wrong question. Because these aren't three independent decisions, they're three pieces of the same machine. Your 401k may be the bridge that allows you to delay another income source. Your pension may become the floor that gives you permission to leave growth assets invested. Social security may become one of the most valuable longevity tools in the plan. And of course your tax strategy determines how efficiently all those pieces interact. The objective isn't delay everything and it isn't take everything. The objective is to create the right income from the right account at the right time. Because the best retirement plans I've seen aren't necessarily the ones with the biggest pile of money, they're the ones where every dollar has a job. And if you're within that five year period of retirement and you've got 401k, social security, maybe a pension, investment accounts, et cetera, and you're staring at all of these pieces wondering how they're actually supposed to fit together, well this is exactly the work that we do. So there is a link in the description below. If you'd like to connect for 30 minutes and have a complimentary strategy session where we can get your questions answered, we can start looking at what you're trying to accomplish, then hit that link, schedule the time. At the very least we are going to point you in the right direction and leave you better than when we found you. So I hope this video helped and we'll see you in the next one.