It costs a lot to retire. The amount of 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 your retirement date, Social Security benefits, and how much you need to save in the interim. There are two ways to arrive at this critical 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 on 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 costs such as health care that will likely increase. As an example, if you have an annual gross (pre-tax) income of $50,000 before retirement, using the 90 percent rule of thumb would show you will need $45,000 per year in retirement.
The advantage of this approach is its simplicity since it reduces 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 inconsistent because it does not account for your individual circumstances. Some people with modest incomes may need 100 percent, while others with more substantial incomes may need less. Some are content with inexpensive hobbies, while others plan for lavish travel. There are those who enter retirement debt free, while others may still be carrying mortgages and other liabilities. The point is using this method can cause you to save too little or even too much for retirement.
The second and more accurate approach requires more work but should result in a plan more tailored to your personal situation and lifestyle. Start by preparing a cash flow statement that identifies your current spending and then adjusts for expenses you foresee will change when you enter into and transition through retirement. Because it is impossible to estimate with accuracy many future payments, including health care costs, use your best assessments and avoid getting caught up in the details.
Whichever approach you use, be sure to account for inflation and taxes. Inflation presents one of the biggest threats to a retiree’s lifestyle because it significantly reduces their purchasing power over time. If $50,000 provides a comfortable retirement today, assuming an annual inflation rate of 3 percent, you’ll need over $67,000 in just ten years to sustain the same lifestyle.
While your taxes may decrease once you stop working, they will still consume a portion of your income and investments. If you need $50,000 to pay your bills and you estimate your effective tax rate (federal and state) at 25 percent, you’ll need to earn over $66,000 from your retirement income and investments.
Being able to retire on your own terms is a dream for most Americans. This first step to turning that dream into a reality requires just a little of your time and a few calculations. You will find it is worth the effort.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com