Journey Into Retirement

DETERMINING THE MAGIC PERCENTAGE

One of the most critical steps in determining your financial situation in retirement is to estimate your anticipated expenses. What you are looking for is that all important magic percentage: The portion of your pre-retirement income that you will need to maintain your standard-of-living in retirement. That percentage feeds all of the other calculations.

If your retirement expenses are greater than you income from sources such as Social Security, Pension, and employment earnings, then you can determine how much you will need to rely on your savings to make up the gap to cover your cost-of-living. Or, from another perspective, how much will you need to reduce expenses.

How do you figure out expenses that could happen some years off? The answer is that you don’t need to because your absolute expenses are not the important number as you plan for retirement. The percentage of your pre-retirement income that you will need is. Of course, you will need to update as you get closer to retirement. However, you can get a good guestimate of what you will need right now by looking at your current expenses and estimating how they will change in retirement.

I am providing some help. Download the Expense Spreadsheet from the “Tools Tab” on this blog and follow along. The numbers in the spreadsheet are a hypothetical example, so delete them and fill in your own numbers. Some of these numbers will come from paystubs or W-2 forms. If you track your expenses in financial software such as Quicken, you can estimate several of the other categories of expenses. This spreadsheet was designed to be reasonably comprehensive, but there is room at the bottom to add miscellaneous expenses not listed elsewhere. Once you have entered your current expenses, we can move on to step #2: estimating your retirement expenses.

EXPENSES THAT COULD VANISH

• RETIREMENT SAVINGS CONTRIBUTIONS: Currently you may be saving through an IRA or a 401k plan. Of course the government imposes limits on how much can be saved each year “before taxes” in each of these vehicles . However, let’s take a 401k plan. Currently (2013), you can save up to $17,500 before taxes. In addition, if you are over 50 years of age, you can contribute another $5,500. When you retire, these contributions will go away. So, if you are contributing to the maximum ($17,500 + $5,500), you can cut $23,000 right away from expenses.

• TAXES: Contrary to popular belief, retirement income from Social Security and Pensions are not tax free when it comes to the Feds. Depending on your income, you may have as much as 85% of social security benefits taxed. However, except from a handful of states, Social security income is not taxed at the state level. Some states exempt all or a portion of your pension income from state taxes. Many of the taxes that you paid pre-retirement will become much less or go away. For example, Social Security and Medicare taxes that came out of your income will go away. If you are working, it is possible, even likely that those taxes will be reduced significantly if you are earning less.

EXPENSES THAT COULD DECREASE

• HOUSING-RELATED EXPENSES: If you pay-off your mortgage before retirement, a large expense could be lifted from your budget. If you decide to downsize your residences when you retire, you could benefit from a slew of expense reductions. These may include reduced mortgages, cheaper house insurance, and lower utility bills. These are changes that vary from person-to-person. However, be aware that a lot of savings can be derived from downsizing.

• RELOCATION: An array of expenses could decrease or increase depending on where you decide to retire. I have several blog posts about this topic. However, if you move to a locations where the cost-of-living is less compared to your current residence, you may see potential reductions in a whole series of expenses. For example, you could save on food and utilities. Property taxes may be reduced and many sales taxes may be reduced or eliminated. Of course, if you relocate to a more expensive locations, then the exact opposite could happen.

• AUTOMOBILE-RELATED EXPENSES: If you have a long commute it is possible that you could save on gasoline, car maintenance, car insurance and the like. However, if your trade long commutes to work for cross-country trips in an RV, all bets are off. Of course, if you get to a point where you are physically incapable of driving, all car-related expenses could go away. Don’t look for these saving early in your retirement, but it could become a reality latter on. Of course, this could increase other travel related expenses because you may still need to get around.

EXPENSES THAT COULD INCREASE

• HEALTH CARE: There are two components to this. First, you will have continuing medical, dental, and visions insurance. You will need to look at your current premiums for coverage through work and compare those to Medicare options. The second source of health care expenses is related to out-of-pocket costs related to medical treatment, drug costs, and costs related to dental and vision needs. Generally, these expenses will increase over the course of a retirement, but this is mostly unpredictable.

• HOBBIES AND TRAVEL: With the free time available in retirement, you may fill your time with hobbies or travel. So, leisure related expenses may increase. Of course, some people turn this into a benefit. If you have a hobby that you can turn into a home-based business, you could use this to bring in additional income.

So, do your due diligence and estimate you expected retirement expenses and the magic percentage you will need. The spreadsheet should help, but feel free to revise this as it applies to your situation. When I made this assessment, I was pleasantly surprised at how much my expenses would decrease with no visible reduction in my standard-of-living. Of course, the future may be full of unknowns and you need to plan for this as well.