How much will retirement cost for you? Simple calculators cannot give an accurate answer. Go through this process to understand retirement expenses.
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You don’t want to retire and then discover you must cut back the way you live.
To avoid that problem, you must project your expenses. There’s no way around it. Unless, maybe, you’re Jeff Bezos. But If you’re not Jeff Bezos, then you need to estimate your expenses in retirement before retirement.
The earlier you do this, the better. However, you can be too early. The sweet spot to start this process is usually in your early to mid fifties—about ten years before retirement.
Here’s what we’ll cover:
- How expenses will differ from your working years to retirement
- Two methods for estimating expenses
- How to account for inflation
- How retirees actually spend their money
- A retirement expense checklist
Spending in retirement is different than it is while you’re working. How much different depends on your situation.
The three categories of expenses that are different in retirement are, increases in spending, decreases in spending, and on the fence expenses.
Once we discuss how expenses differ, we’ll discuss how to actually calculate what you will spend in retirement.
Increases in spending
When you stop working, something has to fill the time that work previously did. This is the biggest area of difference between working and retirement.
Studies show that most retirees actually spend more in their first years of retirement than they did while they were working. This is because you suddenly have the time to do many of the things you previously put off.
Here are some of the most common contributors to increased spending in retirement:
- Grandkids
- Eating out
- Hobbies
- Travel
- Clubs
One person’s dream of retirement may be watching baseball on the couch and reading books on the porch. If that’s you, then your spending may not go up.
Someone else’s dream may be to travel the country, take the grandkids to Disneyland once a year, work on classic cars, and join the golf club. If that’s you, then you may want to up your 401(k) contributions before continuing this article.
Take some time to list all the things you would like to do in retirement.
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Visualize your retirement. How does it feel? Where are you? When do you wake up? What’s your new routine? Put yourself in your future shoes. What do you wish you had more of in your life right now? Maybe it can’t happen today, but that can be a goal for retirement.
Have fun and be creative with your list.
If you don’t want to put things on there because you don’t think you can afford it, leave it on there and build a plan to afford it. You might be surprised by what you can achieve with proper planning.
Creating this list will give you an idea of how life will be different in retirement and thus how expenses will be different.
Going through this visualization process is essential to estimating your expenses in retirement. Retirement life is different than working life. If you don’t think through those differences, you’re going to run into surprises.
Decreases in spending
The next step is to estimate expenses that tend to go down in retirement.
There are four categories of expenses that will likely decrease:
- Work-related expenses
- Savings
- Taxes
- Temporary expenses
Work-related expenses
If you have a long commute to work, retiring can save you quite a bit on gas and maintenance. Other work-related expenses can be home office expenses, work clothes, professional dues, or other travel-related expenses.
Savings
Retiring means no more saving for retirement. So, 401(k) and other retirement plan contributions go away.
That’s the hidden benefit of saving for retirement—it helps you get used to living on less and eases your budget in retirement.
Taxes
This is the most complicated area of retirement spending, but in general, your taxes in retirement will be less than when you were working for a couple reasons:
FICA taxes go away in retirement. These are the Social Security and Medicare taxes withheld from each paycheck. In 2021, it’s 7.65% of your pay, and double if you are self-employed. FICA taxes only apply to earned income, so you don’t pay them on retirement income like IRA withdrawals or pensions.
Social Security has tax breaks. How Social Security is taxed depends on your overall situation, but at most 85% of it can be included in your income. That means that you get a 15% deduction from income taxes on Social Security—and a bigger deduction if your income is less.
On top of that, your overall tax liability in retirement is usually lower because you make less income. But that doesn’t mean you have less to spend. It just means that it takes less income to generate the same amount of spending. First, because the above tax breaks, and second because of no longer saving for retirement.
Also, different retirement accounts like Roths or taxable accounts have better tax treatment in retirement.
Temporary Expenses
Finally, some expenses will go away when you retire or soon after.
The most common of these are expenses related to kids. Private schools and colleges are the biggest ones here. But if kids are still in the house, you have living expenses like food and clothes, plus other expenses like club and sport fees.
Unfortunately, expenses related to your kids don’t usually drop off a cliff when they turn 18—or even when they graduate from college. Still, moving out and finishing school are two big milestones for cutting ties, and then those expenses slowly drop off over time.
On the Fence Expenses
Some expenses could increase or decrease depending on your situation.
These types of expenses are the hardest to estimate, but that also means they are the most important to think through.
The two most important expenses in this category are housing and health insurance.
Housing
The two questions to ask yourself to help determine your housing costs in retirement are:
- Will I stay in the current house or move?
- When will the mortgage be paid off?
Moving will affect your situation the most. You must consider the cost of the new house and the commissions involved with buying and selling, but you also must consider the cost of living in the new location.
If you move to a new state, what are the state taxes like? Property taxes? What’s the cost of living there?
You can find the answer to most of those questions by searching online.
Even if you stay in the same state, moving to a new area can change your costs considerably. You’ll want to look at differences in things like county taxes and HOA fees.
Health insurance
If your company offers good health insurance benefits, then your costs may be higher after you retire. If you pay quite a bit for health insurance now, though, then you may see a drop after retirement.
Medicare starts at age 65, and—if you are retired or plan on retiring by 65—you will want to sign up for parts A and B right away. Those cover hospital care and basic preventive care, but they are not comprehensive and they have no out of pocket maximums. So, most people will want to add additional coverage either through a supplement or an advantage plan. Make sure you understand how Medicare works before deciding when and how to apply.
Think carefully through housing and insurance decisions as you approach retirement. The fewer surprises the better.
You may be unsure about what you will do in these areas. That’s ok. You don’t have to know your exact plans right now. Still, it’s important to consider these expenses and how they might affect your overall retirement expenses. The retirement visualization process mentioned above can help with this, too.
If you are torn between two options—such as staying where you’re at or moving to another state to be closer to your kids—you should estimate your expenses in retirement in both scenarios.
The Back-in Method for Estimating Retirement Expenses
Now that you understand how expenses differ in retirement from working years, it’s time to go through the process of estimating those expenses.
The first method for estimating expenses in retirement is called the “back-in” method because it starts with your income, and then “backs in” to your expenses from there, as opposed to building a budget by looking at all of your expenses first. This is a top down approach, while the budget approach is bottom up.
I prefer this method to the budget method for reasons I’ll explain below.
The back-in method has four steps:
- Start with your take-home pay
- Adjust for taxes and savings
- Subtract temporary expenses
- Add estimated retirement taxes
1. Take-home pay
Take-home pay is how much you make after taxes and deductions.
This is not your salary, it’s how much money actually goes into your bank account. Sometimes it’s called “net income” or “after-tax income.” Make sure you look at your combined take-home pay if you’re married.
If you have a steady job and receive a pay stub, look at your net pay on the paystub. Multiply this by the number of pay periods in a year and that’s it. If your net pay is $2,000 and you get paid twice per month, then $2,000 x 24 = $48,000.
For self-employed, it can be trickier. You may have to talk to your accountant to get the most accurate number.
If your income fluctuates, estimate on the lower end. Or, look at some previous tax returns and take an average.
Account for everything. If you’re already receiving pension or annuity income, include it, and if you have a side business that brings in some spending money, include that too.
For our example, Joe and Jill each have a salary of $60,000 and a take-home pay of $50,000, for a combined take-home pay of $100,000.
2. Adjust for taxes and savings
Looking at net pay on a paystub leaves out taxes and retirement plan deductions—which is a good thing—those will change in retirement so we want to leave them out. However, you still may need to adjust.
Taxes: adjust based on whether you usually receive a tax return or how much you owe at the end of the year.
If you receive a regular tax return, add that back to your take-home pay. That means you are paying more taxes per paycheck than you need to. So, if your take-home pay is $50,000 and you receive about a $1,000 tax return each year, then adjust your take-home pay to $51,000. Similarly, if you regularly pay more taxes at the end of the year, then subtract that from your take home pay.
Savings: include anything you put away that is not part of your employer plan. IRAs, Roths, personal investment accounts, savings accounts, CDs, etc. Subtract this from your take-home pay.
In addition to their employer plans, Joe and Jill like to contribute $7,000 to Roths each year for a total additional savings of $14,000. Also, since they have the maximum tax withholding on their paychecks, they usually receive a small tax return of about $1,000.
They will subtract the $14,000 savings from the $100,000 of income, and add back in the $1,000 tax return to arrive at $87,000. Half way done.
3. Temporary expenses
The second to last step is to subtract out any temporary expenses that might go away in retirement.
In our example, let’s say our couple has a mortgage payment of $20,000 per year that will be paid for when they retire.
So, we subtract $20,000 from our previous number of $87,000 to get $67,000. This is how much our couple needs in their bank account to live on in retirement before taxes.
4. Add Estimated Retirement Taxes
The last step is to estimate retirement taxes, add those to the above number, and then feel good about all the work we’ve put into being able to relax about retirement.
Estimating taxes in retirement is as simple or as complicated as your tax situation. If all you have is a couple IRAs, then it’s pretty simple. If you have any business or rental income, then this can be more complicated and you may want to talk to your CPA. Large non-qualified accounts also add to the complexity here.
We’re going to use a rough estimate for taxes. This won’t be exact—you’ll need an accountant for that—but it will get you close enough for the purpose of estimating our retirement budget.
There are two steps for estimating retirement taxes:
- Estimate your average tax rate
- Use that to calculate your before-tax income
Step one: Estimate your average tax rate
This is the percentage of your income that is taxes. It can also be called “Tax as a percent of income.” If income is $50,000 and taxes are $5,000, then the average tax rate is 10%.
A quick method is to take your budget number and put it into an online tax calculator. Just search for a tax calculator online, and then put the budget number from step 3 into the income field. Also make sure to select the correct filing status.
If you put the expense number of $67,000 from our example into a 2021 tax calculator, the average tax rate is 11.64%, or 0.1164 in decimals.
Step two: Estimate your before-tax income
Next we’re going to use a formula to get the before-tax income.
Remember that up to this point, our budget number has been after-tax. That means that we need all of that money in our bank account to live on. If we subtracted taxes from that number, we would lower our standard of living. Instead, we have to add taxes to the retirement expense number.
To do this, we use a very simple formula: expenses/(1 – ATR)
That’s one minus the average tax rate (ATR) and the expense number divided by that.
Plug in the numbers from our example: $67,000/(1-0.1164) = $67,000/0.8836 = 75,826
That means that in order to get $67,000 in their bank account, Joe and Jill will need to pay about $8,000 in taxes, meaning they will need a total income of about $75,000 in retirement to maintain their current standard of living.
A traditional 80% of income rule would be way off here, because their combined salaries are $120,000. 80% of that would be $96,000. Quite a bit higher than the actual number of $75,000, and harder for them to reach.
Keep in mind that this method doesn’t account for different types of income. As mentioned, Social Security has some tax breaks, and if you have a lot of money in a Roth, these tax numbers could be different.
This method is a quick way to get an idea of what taxes might be so that you are accounting for everything.
The budget method for retirement expenses
Another approach to estimating expenses in retirement involves the “B” word—budgeting. This approach is simpler, but it’s also more tedious—and if you’re not careful—it can be less accurate.
However, this process can be cathartic and give you greater control over your finances.
So, I recommend doing this at least once. You don’t have to do this every month and create envelopes for all your items and follow a strict budget, but a one-time rundown of your expenses can first of all surprise you, and then aid your peace of mind.
To make a retirement budget, start with your current budget. Then, you will adjust it to the differences in retirement.
Step one: make a list of all your current expenses. Everything. Go through your bank statements and credit card statements and get a detailed and accurate accounting of where your money is going.
It’s helpful to make a few categories and lump the expenses into them. Ccommon categories include: bills, groceries, household items, eating out, taxes, hobbies, or travel. Make sure everything is included.
Total it all up and list the final number. Use an annual number. Your monthly expenses may vary, and you also will have certain expenses that you pay quarterly or annually, so it’s best to list your number as an annual figure.
Step two: cut out non-retirement expenses. Look at anything that won’t be there in retirement—retirement savings, mortgage or private school, for example—and cut those out. Rewrite your annual number.
Step three: add in expenses that will be unique to retirement. Health insurance, travel, additional club or hobby fees, etc.
You’ll also want to estimate your taxes in retirement here, because they will be different than what you current pay—probably lower. Follow step 4 in the back-in method to add in estimated retirement expenses, and remove what you currently pay in taxes.
After the three steps, you’re left with your retirement budget number.
I recommend using both methods to estimate your retirement expenses.
If the numbers from each method are about the same, great work. If there is a discrepancy, though, reanalyze your spending. You may find some holes that need plugging.
This is very common. Most people are spending more than they are aware of. That’s not necessarily a bad thing, but it can be helpful to step back and look at where that money is going, and then make a decision about where you want the money to go instead. Maybe you want it to stay the same. Great. At least you have a better perspective on your money now.
How to Account for Inflation in your Retirement Expenses
Inflation is one of the most powerful forces against you in retirement, and if you’re not careful, it can wreck your retirement plan.
If you estimate your expenses in retirement accurately but you don’t account for inflation, your work was useless. On average, inflation causes expenses to double every twenty years. Your retirement dollars buy less and less every year.
Here’s how to adjust your retirement expenses for inflation:
Step one: Find a compound interest calculator. You can find one online with a quick search. Make sure that you are solving for future value, or “FV.”
Step two: Plug in your retirement expense number. $75,000 from our example above. Plug this into the “current principle” field, sometimes called “P,” or “PV.”
Step three: Add in the number of years before retirement. If you are sixty and want to retire at sixty-five, use five for the number of years. This can also be called “n,” or “years to grow.”
Step four: Enter an inflation rate. There’s a lot of research about which inflation rate to use, but everything points to about 3%. In the calculator, you’ll put this in for the interest rate, which might be called “rate,” “i,” or “r,” depending on the calculator.
In our example, if our couple is eight years out from retirement, using 3% inflation means their estimated expenses at retirement are $95,007. Don’t underestimate the power of inflation.
Inflation doesn’t stop once you reach retirement, though, it continues to erode your purchasing power throughout your life. You must protect your retirement income from inflation by using an academic retirement income strategy.
How Retirees Actually Spend their Money
Most retirees follow a common pattern with their spending called the “smile” retirement. It’s called a smile retirement because of its shape.
Early on in retirement, people usually spend more than they did when they were working. This is because there is now time to do things that you couldn’t before. Then, as you check things off the bucket list, you become less interested in spending. So, spending starts to slow down for a time. Finally, late in life, spending starts to climb back up as medical expenses rise.
It looks about like this for someone spending $50,000 and retiring at age 65:
More of a side smile than a full smile, really.
This reinforces the idea that if you estimate your expenses well, account for inflation, and plan properly, you set yourself up for success in retirement. Because, in most cases, the first few years will be the highest spending years.
Retirement Expense Checklist
To recap, here’s what you need to do to get ahead of your retirement expenses and relax about retirement.
- List all of the things you would like to do in retirement
- Go through the back-in method for calculating expenses
- Go through the budget method
- Compare the numbers—if there are discrepancies, find where they come from
- Adjust the number for inflation
- Create a strategy to pay those expenses with investment income
By Michael Sharpnack
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