We hear a lot in the financial media about the looming retirement crisis in our country and in general, retirement confidence is lacking. Therefore, it comes with no surprise that one of the most frequently asked questions that financial planners receive is “am I on track for retirement?” This is commonly accompanied by this question: How much do I need to save for retirement?
Most financial planners typically recommend trying to replace about 80% of your pre-retirement income to maintain your current lifestyle. For example, if you are earning $70,000 you would need to replace about $56,000 per year using the using this income replacement ratio. The problem with the use of this general rule is that retirement income needs and wants vary significantly based on your income and other factors such as your desired lifestyle.
Transitioning from working years to a stage of financial freedom requires more than a one-size-fits-all approach to the planning process. I still believe that the use of the 80% rule is a completely acceptable starting point, especially if your planned retirement date is still a moving target or you just aren’t quite sure how you plan on spending life after work (or the transition to life with a different purpose and motivation). However, once you approach the 5-10 year retirement window, you need to start seriously thinking about your future lifestyle and the income needed to fund retirement by creating a general spending plan for retirement – no matter how you choose to define this stage of life.
It is essential to gain a firm understanding of how you spend your money today so you can create a ballpark estimate of how you will spend your money tomorrow. That’s why it’s important to be a little different than the average person that doesn’t have a budget or personal spending plan in place. A personal spending plan does more than just track where your money is going. If done effectively, it helps you plan future spending while adding some flexibility and factoring in life’s uncertainties.
This simple Budget Planning for Retirement worksheet can be used to assess your desired retirement expense needs in today’s dollars. (Then you can determine your desired retirement income replacement rate based on your projected expenses and input this amount in a retirement calculator to see if you’re on track.) Here are some important factors to consider when determining what your expenses will look like during retirement:
Taxes – With $17 trillion in national debt, there is a widespread assumption that income tax rates will be going up in the future. This doesn’t necessarily mean you will have higher taxes during retirement though. In fact, taxable income is usually lower during retirement. Unless you are working part-time, you will no longer be paying FICA payroll taxes (7.65%). Only up to 85% of Social Security benefits are taxable. There is also a higher standard deduction on your tax return at age 65 and above. You may even be considering a move to a state with no income taxes or lower/more favorable state tax rates.
Savings – Once you reach retirement, you will no longer need to save and invest for this goal. Be sure to factor in your current savings rate across all investment and retirement accounts. If you are contributing 20% of your pay to a 401(k) plan or have 10% going directly into a brokerage account, you are already used to living below your means and don’t need to replace this money during retirement.
Debt – Retiring with a mortgage completely paid off and zero consumer debt is a major contributor to financial confidence. If you plan on retiring without any debt, you will no longer need to include debt payments in your retirement budget. Unfortunately, the reality is that more households these days are approaching their retirement with greater debt loads. This is why the creation of a debt reduction plan is an important retirement planning step and a key factor in determining how much income will be needed in retirement.
Housing – There are a variety of ways that our housing decisions impact retirement income needs in addition to paying off a mortgage prior to retirement (or at least within the first few years). Are you planning on downsizing during retirement? Will you be relocating to get closer to family or possibly moving as far away from them as possible? Are you considering using a reverse mortgage to use equity in your home to provide additional retirement income?
Children – Unless you plan on having a boomerang situation, where adult children return to the household, the process of setting kids free can also free up some serious cash flow. (Of course, if you have student loan payments you are still making on their behalf, that may change the situation.) So if you have young children in the house, be sure to factor in all of the related expenses that may be decreasing (e.g., child care, tuition, food and utilities, clothing). But don’t forget to factor in the “grandparent effect” of redirecting some of those expenses to the grands!
Transportation – If you commute for work, this is an expense that could be going down significantly. Of course, if you are going to be purchasing an RV and cruising across this great land of freedom, your transportation expenses could be going up in retirement.
Travel/Hobbies/Entertainment – Personal retirement planning should always be personal. Realistically assess your retirement goals and be sure they match your life vision and values. For some people, an active lifestyle is the ultimate dream. Others want to slow things down a bit and continue to live frugally. Think about your own retirement goals and how these lifestyle changes will impact your desired income goals.
Health care – Medical costs obviously increase as we age. I played my final adult co-ed soccer match of the season and had a scary thought of how the stress on my knees and other joints may cost me as I get older. The reality is that a couple can expect to spend around $250k in health care costs throughout their retirement years. This figure doesn’t include any potential long-term care costs either. So don’t forget to factor in health care expenses into your retirement budget. Living a healthy and active lifestyle and eating right today can help us save on future health care expenses. Saving in a health savings account is a tax smart way to set aside money for health related expenses to help offset future increases in this part of your budget. If you are planning on retiring prior to Medicare eligibility at age 65, you will also want to factor in the cost of retiree medical insurance if provided by your employer or estimate the cost in today’s dollars of purchasing health insurance through the Marketplace.
How much do you plan on using as your retirement goal? (As you can see, the answer to this question is obviously quite complicated and involves a variety of assumptions regarding some known and unknown variables but don’t let uncertainty about the ideal income replacement ratio hold you back from running a basic retirement calculation to see if you are on track or not.) The commonly used 80% rule is a good place to start but keep in mind that it is nothing more than a general guideline. The closer you get to your retirement destination, the closer you need to look at your actual spending plan for clues as to what your magic retirement income replacement rate should be. Then the next challenge is to figure out how you will be able to generate that income using all available resources such as Social Security, pensions (if you have one), or personal savings.