It’s a dream shared by most – finally hanging up our work hats and enjoying our retirement years. For many people, however, the dream of retirement can seem like an elusive oasis, a hazy, far-away spot on the horizon. Often, we don’t know how much money we’ll need or have a good plan to reach our retirement goal.
Understanding your retirement costs requires some educated guesses – because we don’t know how long we’ll live – and some careful planning to be sure you haven’t overlooked any potentially large expenses that can spoil your retirement plan.
According to USA.gov, people in the US live an average of twenty years after retirement. This statistic provides a useful starting point for planning but should be used as a minimum retirement length. Life expectancy is a moving target that can be influenced by several factors. In general, the trend is that life expectancy is increasing. Recent downturns in average life expectancy can be attributed to an increase in drug overdoses and suicides. Absent these risks, life expectancy continues to increase, largely due to medical advances. Many illnesses and diseases that were fatal in the past or reduced life expectancy can be successfully treated now.
It’s also important to consider what goes into an average. Low numbers are included as well, including the lower ages of those who died early in life. Using averages that include young deaths may not be useful for estimating life expectancy after retirement.
SSA.gov provides a life expectancy calculator that accounts for mortality risks early in life and increases life expectancy once you reach certain age milestones.
For example, a male who is 50 years old can expect to live 82.1 years as an average estimate. If that male reaches age 62, estimated life expectancy increases to 84.5 years. At age 67, life expectancy is estimated at 85.7 years and if that male reaches age 70, life expectancy increases to an estimated 86.5 years. For a female who is 50 years old, the pattern is similar with an estimated life expectancy of 88.5 years if that female reaches age 70.
If social security is part of your retirement plan, you’ll want to calculate the difference between when you qualify for full retirement benefits, currently age 67, and the estimated life expectancy based on reaching age 70. For people age 50, this is about 20 to 22 years. The numbers don’t change dramatically for younger people. For example, a male who is 20 years old can expect to live an estimated 88 years if he lives to age 70. This is 1.5 years longer than a male who is age 50 now.
While estimates can be a useful tool for determining how long you’ll live after retirement, it’s wise to pad the numbers when setting a goal. With a bit of luck and a healthy lifestyle, maybe you’ll be one of the people who brings up the averages by living longer than most.
We can work with an estimate of living 25 years after reaching retirement age. Using a lower number puts you at risk of running out of money at a time when it may be difficult or impossible find another income source.
Many experts use the “80% rule” to estimate retirement income needs. This rule of thumb states that to maintain the same standard of living in retirement, you would need an income equal to 80% of your income before retirement. Some financial planners stretch the 80% rule to include a range between 70% and 80%. There’s some room for flexibility depending on your ongoing financial obligations.
Some of the primary reasons that support a reduced income in retirement revolve around work-related expenses. More specifically, the absence or reduction of work-related expenses contributes to a lower income requirement in retirement. If you were putting a couple hundred miles on the car commuting each week, that expense goes away. You’ll probably drive much less. Other work-related expenses like dry cleaning, eating lunch out, and purchasing suits or dress clothes will also be reduced or might go away altogether.
Your taxes are also likely to go down in retirement. Specifically, FICA taxes which pay for social security and Medicare only apply to wages. Between those two taxes, you’ve recouped about 8% of your income if your retirement income comes from savings as opposed to wages. It’s likely that your income will be taxed differently as well. Income withdrawn from a traditional IRA is taxed as regular income while dividends are taxed at a lower rate. It’s possible that you’ll be in lower tax bracket overall because you’ll be drawing a lower amount of income.
It’s likely that you were saving for retirement during your working years. This monthly “expense” is no longer an expense once you’ve reached retirement. Depending on how much of your income you were saving during your working years, the monthly cash flow difference can be considerable.
The 80% rule also assumes that your mortgage will be paid off by the time you retire, eliminating one of the largest monthly expenses in most households. However, maintenance, home insurance, and property taxes will be ongoing expenses, as well as homeowner association fees if there’s an HOA where you live.
If we assume that you’ll live for 25 years following retirement and that you can maintain a similar lifestyle on 75% of your prior income, splitting the difference between the 70% and 80% estimates, we can do the simple math.
25 x (income x 0.75) = annual income requirement
If you were earning $50,000 before retirement, you’ll need $37,500 per year. Over 25 years, that equals $937,500.
The simple math is a bit too simple, however. It assumes that your retirement savings isn’t growing at all while you draw down the balance.
If you allow for conservative growth of 8% and assume that you’ll be in the 22% tax bracket, you’d need less than $500,000 to last throughout your 25-year retirement. Theoretically, the balance is still growing as your investments post gains in most years.
We still haven’t accounted for inflation, though. Over 25 years, you can be certain a gallon of milk and a gallon of gas will go up in price, along with most other things. If you allow for a 3% rate of inflation which adjusts your monthly income needs by 3% each year, you’ll need $640,000 to provide income for your retirement.
The math can get complicated if you have to account for both an average rate of return on investments as well as for annual inflation which will increase your income needs. There are several good online calculators that can help you do the math for your particular income needs.
In the last example, we assumed the only income you would have is your retirement savings. The calculation ignores social security and any other types of income you might have, like investment real estate, pensions, annuities, or even part-time work. Any of these will reduce the amount of money you’ll need from savings because you won’t have to draw down your savings as quickly.
Social security often isn’t enough to live on comfortably, but it can take a bite out of your total income needs. In the earlier example, to retire after making an income of $50,000, you would need $3,125 per month ($37,500 per year). A 50-year old male making $50,000 per year would qualify for $940 per month at age 62. This is the lowest amount social security would pay assuming you’d worked consistently. If you wait until age 67, the monthly benefit is larger and continues to grow larger up to age 70 if you wait to take your benefit.
If you had $940 coming in from social security, your monthly draw down from your investment accounts can be reduced. The $640,000 of retirement investment savings from the last example will now last 30 years instead of 25. Alternatively, you can pay for 25 years of retirement with only $450,000 in retirement savings if you are earning $940 per month from social security.
Social security benefits increase if you wait before drawing your benefit, reaching the highest monthly payout at age 70. The $940 per month you would get at age 62 can increase dramatically if you wait until age 70 before drawing your benefit. At age 62, you would get about 70% of the benefit. Depending on when you were born, you may qualify for full benefits (100%) at age 66 or age 67. By waiting until you reach age 70 to take your benefit, you can increase your benefit to 124% to 132%, again depending on when you were born. By waiting, your income requirements from other sources, like your retirement savings, is greatly reduced.
You may also have income from other sources, like royalties, pensions, rental income, or even wages for part-time or freelance work. Every penny counts and will reduce the amount you need to draw down from your retirement savings, helping your savings to last longer and perhaps allowing you to enjoy some travel or recreation.
There are a several expense categories that can significantly affect how much it will cost to retire.
The biggest change in retirement is often your source of income. Instead of decades of growing wages, this time in your life often has limited income. The challenge is to make it last and to save enough for life’s surprises, many of which cost money.
How much it will cost to retire depends largely on what type of lifestyle you want to maintain. In many cases, it’s possible to still enjoy the nicer things in life but doing so less frequently will help your savings to last. Experts still recommend planning to replace 70% to 80% of your pre-retirement income with other income streams, including social security, pensions, retirement savings, investments, or other income sources. However, with some discipline both before retirement and during retirement, you’ll be able to put yourself into a stronger position to make your retirement savings last and you may be able to get by just fine on much less than you earned during your working years.