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March 3, 2013

Calculating the cost of your retirement

Retirement is expensive. How much money you will need each year when you stop working depends on your individual circumstances and the kind of lifestyle you expect to live.

Your estimate will be the starting point of your retirement plan and will drive many of the other planning decisions you make, including those regarding Social Security benefits, your retirement date, and how much you need to save in the interim.

There are two ways to arrive at this important number.

The most popular method is called the Income Replacement Ratio. It is the percentage of your working, pre-tax income needed to maintain your standard of living in retirement. It is based upon industry and academic studies of retirees and generally indicates that most seniors need between 70 percent to 90 percent of their pre-retirement income.

The assumption being that income and FICA taxes, and retirement savings contributions that consume 10 percent to 30 percent of a person’s income will be reduced or end in retirement.

It also assumes that work-related expenses that decrease in retirement will be offset by expenses such as health care that will likely increase. For example, if you have an annual gross (pre-tax) income of $50,000 before retirement, using the 90 percent rule of thumb would indicate you will need $45,000 per year in retirement.

The advantage of this approach is its simplicity, since it eliminates much of the work required to make projections about future expenses. Although it can be used as a starting point for those in their 20s and 30s, for those nearing retirement, this “one size fits all” approach is seriously flawed because it does not account for your individual circumstances.

Some people with modest incomes may need 100 percent while others with larger incomes may need less. Some are content with modest hobbies while others plan for expensive travel. There are those who enter retirement debt free, while others may still be carrying mortgages and other liabilities. The point is using this approach can cause you to save too little or even too much for retirement.

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