A common guideline is that you should aim to replace 60-80% of your annual pre-retirement income. You can replace it using a combination of savings, investments, Social Security, and any other income sources (part-time work, a pension, rental income, etc.). The Social Security Administration website has a number of calculators to help you estimate your benefits.
It’s important to consider how your expenses will change in retirement. Some, like health care and travel, are likely to increase while some recurring expenditures will go down. You no longer need to dedicate a portion of your income to saving for retirement. You may have paid off your mortgage and other loans. However, you may wish to increase your traveling for the first few years of retirement and then start making gifts to family in later years. This may require you to aim to replace 100% or even 110% of pre-retirement income.
Regarding taxes in retirement, most retirees have been saving for years in their pre-tax 401(k) or 403(b) workplace retirement accounts. One benefit of these plans is that while contributing, you did not pay income tax on any of the income you deferred to your account. The downside to this is in retirement, you will have to pay tax at ordinary income tax rates.
The great news for most retirees is that their post-retirement tax brackets are typically lower than their tax brackets during their working years. This makes saving while working into a pre-tax account like a 401(k) or IRA a great option. However, if you have a substantial pension benefits or a large Required Minimum IRA Distribution, you could end up in a higher tax bracket post-retirement.
If you weren’t aware, pre-tax retirement accounts like 401(k)s and IRAs have an IRS mandate to begin taking distributions by age 72. These Required Minimum Distributions (RMDs) can be quite the surprise for folks that will not need the full distribution but will be required to take them anyway.
If this sounds like it could be you, there are a number of tax planning techniques that can be implemented to help lower your taxes in retirement. We recommend working with a financial planner that specializes in tax planning in conjunction with your tax professional to help you plan for future tax consequences.
Cash Flow Planning
A great place to start with determining how much you’ll need to retire is by creating a written cash flow plan.
The best place to start with determining your ability to retire is to create a detailed record of your required expenses. We like to break up these expenses into two main categories: living expenses and variable/periodic expenses.
Living expenses should be expenses that aren’t expected to change drastically on an annual basis and are required for your standard of living. Utilities, gas, groceries, and personal care are common examples of living expenses. Periodic/variable expenses are items you are planning to include in your spending, but may be more flexible in the amount you spend. Examples may include vacations, dining out, and other lifestyle spending. You would also want to include any future expenses such as roof replacement and vehicle purchases.
Once you have a clear list of your required monthly/annual expenses you will know what your income need will be in retirement. (Pro tip: the first time you create a cash flow plan, leave a bit of wiggle room as most people miss a few things)
Once you know how much income you’ll need, you can start creating a plan to strategically liquidate savings in retirement. This is where is gets a bit more tricky.
Many people are great at the initial creation of their cash flow plan but forget the silent killer of long-term planning: inflation. Inflation is defined as: “A general increase in prices and fall in the purchasing value of money.” In simple terms, a dollar today will not be able to purchase the same amount of goods as a dollar in the future as prices for goods increase over time. The average cost of a loaf of bread in 1990 was 75 cents whereas today it’s over three dollars.
General inflation has been about 2-3% on average over time. The cost of healthcare has increased higher than average inflation (typically 8.5%). The average cost of college has increased by 7%. Accounting for inflation is one big missing variable many folks planning retirement on their own often overlook.
We use a real rate of return in our clients’ Financial Plans so that we can accurately understand the purchasing power of future dollars. We use real rate of return by removing inflation from income and expenses (except for medical and college expenses) and the rate of return on investments.
For medical expenses, we assume a 5.5% inflation rate. For college costs we assume a 4% inflation rate. For your investments, we use a real rate of return of 4% (based on a 60% equity/40% fixed portfolio). This is an 7% rate of return – less an inflation rate of 3%. (The historical rate of return for stocks is 10% and bonds is 6%).
Once you have your cash flow plan and have accounted for inflation, you can now start to determine how much you will actually need for retirement.
Our hope is not to frighten you but to help you think through all the potential costs of retiring before you make the leap. If planning for retirement is making your head spin, we are here to help. If you are considering retirement in the next 10 years or less or are just wanting to ensure you are saving for retirement in the right ways, we would love to speak to you on a complimentary introduction call to see if our services may be right for you.
In celebration of our 30 -year anniversary, we are also offering our Initial Financial Overview at a reduced cost of $300 (normally $775).
This service is a personalized 2-hour review of your entire financial situation. From this meeting, we will provide you with specific recommendations in written form. Since we do not sell any products or accept commissions, our recommendations will always be objective and free from bias. Our ultimate goal is to help you get clarity on your current situation and provide you with steps on how to transition successfully and confidently into retirement.
If this sounds like something you would be interested in, or if you would like to schedule a complimentary introduction call, you can schedule a time using the link below: