Many times when planning for retirement people focus on maximizing contributions. It’s often assumed that by doing so everything about retirement will fall into place. That may be so, but how do you know if you’re succeeding until you’ve defined your target?
When it comes to retirement, the targetâ is a credible income number, as in how much will you need to live the life you want to live, taking into account your expected living expenses, sources of income, and the effect inflation will have on it. You can do that by going through some steps.
Figure out how much income you’ll need in retirement
To keep the calculations simple, many financial planners advise using a simple method, such as 80% of pre-retirement income, but I think this can also be an oversimplification. The fact is, you don’t live on your gross income, but on your take home pay, so basing retirement needs off of gross income can easily be distorted.
When you retire you won’t have as many off the top expenses, such as contributions to pension schemes, retirement plan contributions, FICA taxes (which apply only to earned income) and cafeteria plan deductions. Instead calculate how much you spend in a typical month based on an analysis of your spending. You may need to review your checking accounts and credit card statements to get a complete picture.
Once you have an average spending number, it’s time to make adjustments. If you plan on having your mortgage and any other debts paid off by the time you retire you won’t need to factor these into your retirement income requirement. Obviously if you have children you can also subtract any expenses related to their care. And if you plan to be fully retired, or at least not working outside your home, you can also deduct work related expenses, such as gas, tolls and higher maintenance owing to more miles driven.
On the flip side there may be expenses that you anticipate being higher because of retirement. It may be hard to estimate, but if you plan to travel more than you do now you’ll have to do your best to calculate how much to add for it. Premiums for long term care insurance are also a possibility, as are a higher allowance for medical costs.
Factor in inflation
Once you have a have a baseline annual income requirement, you’ll have to make an adjustment for inflation. This is a completely necessary step since your retirement is probably decades away.
The idea is to be sure that the income you’re preparing for at retirement will be relevant for that time and not one that’s based on today’s price levels.
Estimating inflation is not an exact science; you have to make what you hope will be a reasonable estimate of what inflation will be in the future and that can be little better than a guess. Perhaps the most accurate way to do this is to take the number of years between now and when you expect to retire, and let’s say its 30 years, then use the inflation factor for the past 30 years to make the projection. You can get the inflation number for previous years by using an inflation calculator.
You might determine from this, for example, that the $36,000 income you need now might be something like $100,000 30 years from now. That’s the income you must prepare your investments to deliver by your retirement.
Consider your sources of retirement income
OK, when you calculate inflation into retirement plans the numbers can get scary. But it’s not really as bad as it looks. You will probably have other sources of retirement income beyond that which will be provided by your retirement investments alone. These sources include Social Security, employer pensions and any earned income you expect to have at that time.
You can actually deduct these from your income requirements before making inflation adjustments, but with questions surrounding the future of both Social Security and employer pension funding, it might be a safer bet to be at least a bit conservative as to how much you expect to receive from these sources.
Your investment retirement choices
Once you have a solid idea as to how much income your investments will need to provide in retirement, it’s time to consider what vehicles you’ll use to hold and grow that money. Fortunately, there’s a wide selection here, and you can work this to suit your anticipated future needs.
For most people, an employer 401k or 403b plan is the best way to build up large amounts of retirement savings. But even if you have these plans to invest in, don’t stop there. Traditional IRA’s often provide greater investment flexibility than employer plans and they can be an excellent supplement to a company plan, especially if you need to accelerate your retirement savings.
Still another choice is a Roth IRA. You have the same contribution limits as with a traditional IRA, but the Roth adds tax diversification to the mix. There is no deduction for Roth IRA contributions in the year they’re made, but you will have tax free withdrawals of both principal contributed and the earnings they accumulate if you hold the plan until retirement. This means that at least some of your retirement income can be taken tax free, which will also have the benefit of reducing the amount of income you’ll need for retirement.
If this all seems a bit complicated, that’s because it really is. That’s why it’s so important to know exactly how much income you’ll need, and to have a solid strategy for how you’ll accumulate the assets to provide it. But once you know what those numbers are, it’s just a matter of setting your plan and sticking to it. The payoff is the retirement of your dreams.
About the Author: Joe DiSanto is the founder of the firm Play Louder. He is an independent CFO, providing financial management and business consulting to small firms and family offices. You can read more about his ideas on the financial planning process here.
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