We have a simple way of estimating your retirement expenses. Because, without a fairly accurate estimate, it is extremely hard to create a reliable retirement plan.
If you’re one of those people who already has a detailed budget and tracks it regularly, you may already have this all figured out. However, this is a good way to double check your estimate to be sure it holds up. Think of it as getting a second opinion.
We always want to be conservative in our approach. We want to under-estimate anything that will work to your advantage and over-estimate anything that might work against you. So in this case, we would rather over-estimate your expenses than under-estimate them.
So let’s start with your current net income. Think of this as how much money hits your bank account each month. Not your gross pay, but what you actually receive after everything that’s withheld, like taxes and insurance and other benefits or retirement savings. For this example, let’s assume that number is $9,000.
Now we want to ask, how much of that $9,000 is actually going toward living expenses each month, and how much is usually left over? In this case, let’s assume you routinely have about $500 left over at the end of the month.
So that means $8,500 is being spent. Now let’s subtract any of those living expenses that will go away when we retire. This might be a mortgage, a car payment, dry cleaning expenses, the cost of commuting back and forth to work, if that’s significant – or anything else you can think of that will not be an expense in retirement. And remember, if we’re subtracting our mortgage payment, we only want to subtract the principal and interest portion, not the taxes and insurance, because those will continue.
If you plan to change your living arrangements, maybe you plan to downsize or move to a new location, then you need to consider how that might affect your current housing expenses, too.
For simplicity’s sake, let’s assume you’re staying put, but you’ll save $1,000 by having your mortgage paid off. So that drops the $8,500 to $7,500 of monthly expenses.
Regarding debt: as we have said, retirement is a cash flow problem. Not a net worth problem. You will be better off in retirement having lower overhead. Paying debt adds to your overhead. Reducing or eliminating debt is key to minimizing your monthly expenses. This leaves more available cash flow for discretionary spending on fun things.
We fervently believe reducing or eliminating debt prior to retirement is extremely helpful in the long run.
Now once you’ve subtracted any expenses that will go away, you want to add any expenses that might be new. Examples might include travel or healthcare costs. Again, you want to be sure that your estimates are generous enough to be realistic. Remember, when in doubt, you want to overestimate your expenses.
So let’s assume you want to add back in some additional funds for future healthcare expenses. Normally I include two separate amounts – one for Medicare premiums and another for out-of-pocket expenses, but to keep this simple, let’s just add back in $1,000/mo. total for both.
This brings your projected monthly retirement expenses up to a total of $8,500/mo. That’s $102,000 annually. This is a net, after-tax number. So again, to keep things simple for this example, let’s assume a 20% average tax rate, that gets us up to $127,500 a year of gross income needed for retirement. To plan for anything less would be somewhat naive.
This is current dollars. So it needs to be grown by around 2% compound inflation for your entire life expectancy. Otherwise, your income won’t allow you to retain your current standard of living.
Now 2% may not sound like a lot, but when you increase it by 2% each and every year, on a compounded basis, for the next 30 years or so, it has a huge effect and should be more than sufficient.
Remember, this is just the starting point. You’ll eventually look at the finished plan and decide if you think this number will work. If not, you can revisit it, along with all of the other variables, and make whatever adjustments are necessary. And I recommend doing that exact same thing every single year, reviewing the plan to be sure you remain on track, regardless of what may have happened in the preceding year.
That should be much easier than trying to track every one of your expenses for an entire year. In fact, I actually find this approach usually proves to be very accurate.