“Now YOU can learn about retirement planning in plain English. Planning for retirement can be confusing. I cut through all the industry jargon so YOU can learn how to achieve your retirement goals.”
Income in retirement is everything.
Think about it…
If you can’t pay your bills then nothing else really matters. You’re not going leave money to your alma mater, to your kids, to your grand kids…
Unless you can take care of yourself first.
Here are 2 approaches you can take to estimate how much income in retirement you will need:
- Income Replacement Ratio Method
- Specific Expense Method
It’s wise to use both methods and check the results against each other. Let’s take a look at them.
Income Replacement Ratio
This first approach is more a “shoot from the hip” approach. But it’s better than nothing. A standard rule of thumb is that most retirees will need between 70%-80% of the pre-tax income in retirement.
First of all it’s a rule of thumb. Rules of thumb should be used as guidelines.
When it comes to something as important as you being able to retire comfortably I recommend getting a specific number for the amount of expenses you will have in retirement.
Nevertheless, the income replacement rules of thumb can give you an idea of what level of income you will need in retirement.
Why 70%-80%? Let’s look at an example.
If you are bringing in a pre-tax salary of $60K/year to your household the truth is you are not actually living on that full amount.
First, you are paying approximately 7.5% in FICA tax.
Second, you are also very likely contributing to a 401(k). Let’s assume that if you contribute 6% you get your full employer’s match (all employer plans are different on their matching contributions).
Third, you are also paying federal income taxes. Tax brackets change over time, but let’s assume you are paying an effective rate (after all deductions) of 10%.
Fourth, you may be setting aside additional funds in savings outside of your 401(k). Let’s say you set aside 3%.
If you add up all of these expenditures (7.5% + 6% + 10% + 3%) that equals 26.5%.
That means of the $60K pre-tax salary, only 73.5% of it was being spent just living life.
In other words, for this example the $60K/year pre-tax salary could be used to estimate a spending requirement in retirement of about $44K.
We could add other elements to this as well, such as how spending would be less in retirement because you would presumably have paid off your mortgage.
But at the same time we could just as legitimately argue that healthcare spending (even with access to Medicare) will go up in the future.
So let’s just leave it at 73.5% for this example.
But what happens if someone is making more money, say $150K/year. Well, the numbers will look similar except the effective federal tax rate will be higher. Assuming a married couple, the effective federal tax rate (due to the tax bracket methodology) could be approximately 20%.
Using this tax rate and adding in the 401(k) contributions, external savings, and FICA tax, the income replacement ratio for this couple would be 63.5%.
The lower income replacement ratio is simply due to the fact that they are already having a higher amount taken from them in taxes, and therefore are not really living on that money anyway.
If they are getting by without that money before retirement, it stands to reason they can probably get by without that money after retirement.
So there is a range. And just so we are not being too aggressive with this, let’s go with an income replacement ratio in the range of 70%-80%. You may could retire comfortably on less. But I’d rather you have the extra income and not need it, than to need it and not have it.
This method of calculating your spending needs in retirement is good for investors that don’t want to take the time to track where all their dollars are going each month.
It’s also good for investors that are 5-15 years away from retirement. They may not know what their spending needs will be in retirement because it is still a good way’s off. So this approach gives an estimate.
Now let’s talk about another way.
Specific Expense Method
This method is more accurate because it gets in to the specifics of your spending habits… and thus spending requirements.
A lot of people will not take the time to go through this step. That’s why I gave you an alternative method above using the Income Replacement Ratio.
But I would encourage you to take a moment and track your expenses.
Here’s where to start…
Your credit card statements. Your credit card company tracks every time you spend money on their card. So look at your latest statements and see where your money is going.
The next place to go would be your checking account. You probably have automatic drafts coming out of it to pay for things like your mortgage, utilities, health insurance premium, life insurance premium, and more.
The last thing to track is your cash. You know, the money in your wallet or purse. This can be harder to track because no one such as a credit card company or a bank is keeping track of this for you.
Here are 2 methods:
- At the end of each day take 5 minutes to write on a piece of paper any money you spent. You can take this information and input it into your budget. Admittedly, this will take time every day. But it works.
- Another option would be to write down the amount of money in your wallet at the beginning of the month. Anytime during the month you add cash to your wallet or purse from the ATM machine or other sources, be sure to write down that addition as well. Then at the end of the month count how much cash is still left in your wallet. Take the beginning value plus any cash additions you made throughout the month and subtract the ending value, and that’s how much cash you spent during the month.
Use this worksheet to help you categorize your expenses as you are going through this exercise. If you think your expenses will change once you retire you can estimate what they will be in the far-right column.
Compare the results of both methodologies
If you’re willing to put in the work, do both methodologies. You may find that doing the Specific Expense Method puts you very close to the 70%-80% spending need range compared to your current pre-tax income.
If after doing the Specific Expense Method your number is well below the 70%-80% range, then dig deeper. You may have overlooked some expenses. Or maybe you just don’t require that much in spending because you live a frugally fulfilled life. That’s awesome!
What’s great is that you can use both methodologies to check against each other.
And if you don’t want to put the time into tracking all your expenses (although I recommend you do), then you can use the Income Replacement Ratio methodology. Just back out the percentage of your pre-tax income you use for savings contributions and for taxes. What’s left will be an educated estimate of the percentage of your pre-tax income you need to meet your spending requirements.