What’s Your “Number?”
If you’re like most people approaching retirement, one of your main concerns is what level of income you are going to need in retirement.
If one were to Google the phrase “Retirement Income Replacement Rate”, they would find about 1.3million results. It seems every financial website, financial calculator, brokerage firm, and mutual fund company has their own perspective on the appropriate “Number” – that is, the percentage of your pre-retirement income that you need in retirement.
Many so-called “retirement experts” like to use a specific number, or “Rule of Thumb” to identify the appropriate number. In reviewing many of the top search-engine results, one would be led to believe that the number falls somewhere between 70% and 135%. That’s a big variation. Why the disparity of results? Simple. Because there are so many variables and many different assumptions. It might seem straight-forward, but let’s look at a few reasons why.
First, your taxes are most likely lower in retirement. Excluding any “work” you do in retirement, you won’t pay any payroll taxes (social security) on your income. That alone will save you 7.65% of your income, the current employee rate (excluding the current, temporary social security tax “discount” in place). Also, much of your income may not be taxable at ordinary income tax rates. For example, Social Security income is taxed between 50-85% (or zero if your income falls below the taxable threshold). Income received from capital gains on securities is taxed at a lower capital gains rate, and certain dividends are taxed at preferential rates as well.
Second, you will have fewer income “deductions” in retirement. I’m not talking about tax deductions, but payroll deductions. While working, if you were contributing to your company-sponsored retirement plan, those payroll deductions go away. And there may be other deductions as well such as life insurance, short and/or long-term disability, and health insurance. Now, some of these expenses may now take other forms, such as personal life insurance policies and other forms of health insurance (ie. Medicare, Medigap policies, etc.). But overall, you may find that your “take home” pay is higher.
Third, there may be expenses that have phased out of your life, such as your mortgage, college expenses, raising of children, and possibly a smaller home or, if you choose to move, a lower cost of living overall. You might no longer be saving for major expenses like a home, college costs, weddings, and significant home expenses (new furniture, appliances, etc.) that you tend to purchase when you are younger and establishing your household. So there is less need to set aside savings for those items.
Finally, you have more free time on your hands, and the desire to fill that time with travel, hobbies, dining out, spoiling the grandkids, and a general desire to make up for your leisure “lost time”. With that comes added expenses.
Although these various factors seem to compound the issue of pinpointing your true “number”, the exercise can be quite simple – and it doesn’t involve creating a line-by-line household budget.
In my financial planning practice, I have found the simplest way to come up with your income needs is to follow this exercise:
Begin with your take home paycheck every month. In other words, what gets deposited into your bank account. Depending on how often you were paid (weekly, bi-weekly, etc.), you will have to figure out your annual take-home pay and divide by 12. This is your monthly take-home pay. This was the amount you were actually living on. So for example, let’s say your gross salary was $75,000, but after taxes, social security, state and federal income taxes, and 401K contributions, your take home pay was $50,000, or $4,166 per month. So your starting point for after tax income needs in retirement is $4,166 per month.
Begin the process of adding back and taking away adjustments to your paycheck that will change in retirement.
First, determine what tax rate your income will be subject to. You will need to determine what level of taxation will apply to your various forms of income (ie. IRA and 401K withdrawals, interest and dividends, capital gains, Social Security income, etc.). Do not assume the same level of taxation as during your working years. You may need the assistance of your tax professional on this one. If you have always done your taxes yourself, and you are not completely comfortable with estimating this, I strongly recommend working with a tax professional and financial planner for at least a year or two to get yourself set up properly for retirement. A good financial planner will help you estimate the amount and forms of various income you will have, and your tax professional will make the necessary tax estimates.
Make changes in your budget for expense changes such as a paid-off mortgage or any other major additions or changes to your expenses. Don’t forget to include things like insurance (ie. medical, long-term care) that may have been covered by an employer, or may be new to you. Also, do your best to anticipate unforeseen expenses like the financial support of an adult child or an ailing parent. And remember, you will always need to replace things like cars, roofs, and major appliances that have aged or broken down.
Finally, make adjustments for lifestyle changes – no commute (less gas), more or less eating out, travel, entertainment, etc.
The result will be what amount of income you need on a regular basis. So in our example, we started with gross income of $75,000, take home pay of $50,000, and then adjustments to what your needs will be in retirement – without going through every line-item in your budget.
In our next installment, we will review how you are going to create the income that you need in retirement, including social security, pensions, retirement accounts, annuities and savings.