As people plan and prepare for retirement, many underestimate their income needs. There’s a rule of thumb that people should plan to replace 70% of their pre-retirement income in retirement. However, I see that most people will need to replace 80% to 90% of their pre-retirement income.
Whatever your needs may be, creating a retirement income plan is an important part of feeling secure in retirement.
You may have a rough idea of your expenses, but it’s time to take a closer look to determine how much your lifestyle costs. Examine your credit card and bank statements, and track all of your expenses over the past six months. This longer time frame is important so you don’t miss any quarterly or biannual expenses, such as your property taxes.
Put your spending into categories: Include necessary expenses, such as your mortgage, insurance premiums and recurring medical bills. Also include your variable expenses, such as travel, dining out and personal care. Take a look at your pay stub to understand how much you’re paying for health insurance, taxes and your contributions to a retirement savings account, such as a 401(k).
Once you’ve figured out how much you’re spending now, take out any expenses that will disappear in retirement. Those might include commuting costs, your dry- cleaning bill and recurring contributions to your retirement accounts. After eliminating those expenses, it’s time to figure out how much your retirement lifestyle will cost.
This can be tricky, but it’s important to get as specific as possible when talking about your goals for retirement to create a realistic plan for how much money you will need. How will you spend your time? From traveling more to new hobbies and higher entertainment costs, these expenses are important to include. Retirees often spend more than they expected in the first few years of retirement because they are eager to take advantage of their newfound free time.
When calculating about how much income you will need to last you through retirement, divide it into three phases:
- During early retirement, your spending is likely higher. Retirees at this stage are often traveling and actively enjoying their freedom. Depending on your health, this phase is usually ages 60 to 70.
- Then, spending slows down a bit in the second phase of retirement. Due to health or age, you will likely travel less and stay home more. This phase usually spans the 70 to 80 age range.
- In your third phase of retirement, your spending will likely increase once again due to health care costs. Medical bills or long-term care expenses might replace what you used to spend on travel and entertainment. This is generally true for those 80 and older.
Your tax liability will change in retirement. If your nest egg is mostly saved in tax-deferred accounts, including a traditional 401(k) or IRA, that money is not all yours. The IRS will tax any and all withdrawals from those accounts, and you’re required to start taking that money out at age 72. Depending on your withdrawals and other income in retirement, up to 85% of your Social Security check might be subject to taxes as well. Sit down with a financial adviser to determine the most tax-efficient way to withdraw money from your retirement accounts.
Inflation is the rate at which the price for goods and services rises, and consequently, the purchasing power of a dollar falls. When creating your income plan, factor in 3% for inflation. Inflation is hard to predict, but it is an important thing to include. For example, if your average monthly grocery bill is $100, assuming a 3% inflation rate, that bill will be $103 next year. While $3 does not seem like a lot of money, your retirement could last 20 to 30 years, and inflation will definitely impact your spending and income needs. At an inflation rate of 3%, that same $100 grocery bill 30 years down the road would be over $240.
Health care is one of the biggest expenses for retirees. To estimate your individual health care costs, look at your current health and your family history of illness or chronic diseases. You should also research and decide which Medicare plan you’ll choose. Medicare Part B, Part D, Medigap and Medicare Advantage all provide different coverage. And remember, Medicare doesn’t cover everything! Dental care, hearing aids and eye exams are not covered. Be sure you’re factoring in these expenses.
Make adjustments every year or with any major life event. Your needs will change, and your expenses will change too. Once you’re in retirement, look at how much you’re withdrawing from your retirement accounts each year, compare it to your plan and make adjustments as needed.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Founder & CEO, Drake and Associates
Tony Drake is a CERTIFIED FINANCIAL PLANNER™and the founder and CEO of Drake & Associates in Waukesha, Wis. Tony is an Investment Adviser Representative and has helped clients prepare for retirement for more than a decade. He hosts The Retirement Ready Radio Show on WTMJ Radio each week and is featured regularly on TV stations in Milwaukee. Tony is passionate about building strong relationships with his clients so he can help them build a strong plan for their retirement.