Newly retired employees often rave about the joy of throwing the alarm clock in the trash and spending their days doing satisfying activities. But let’s be honest: Most new retirees are probably a little nervous about the financial aspects of retirement.
Retirees are often advised to estimate that they will spend 75% to 80% of their earned income in retirement, but a paper by David Blanchett, formerly of Morningstar and now with PGIM, found that high income, We found that high-savings households may need it. Retirement income can be as little as 60% or less of pre-retirement income, but low-income, low-savings households may need closer to 90%.
Predicting your actual income replacement needs can be difficult, so here are some important steps to take.
Step 1: Find a realistic baseline for your income
If you are nearing retirement and want to maintain the same standard of living as you had during your working years, it makes sense to use your current salary as a baseline. However, if you are younger, say in your 40s, your current income may not reflect the amount you want to spend when you eventually retire, so you may want to take a little less of your base income for retirement planning. It may be wise to increase it by increments.
Not only do you tend to get cost-of-living adjustments as the years go by, but career advancement can also lead to higher salaries over time, which you may want to “replace” after you retire. As Blanchett pointed out in his paper, the average college graduate retires with a salary that is 50% higher than it was at age 25. For those with lower educational attainment, the increase in salary over time is less pronounced.
Step 2: Subtract your savings rate
Find out what percentage of your salary you have saved or expect to save by retirement and subtract it from your base pay amount.
In general, it is easier for people with higher incomes to save a larger percentage of their paychecks during their working years than it is for people with lower incomes. A household that saves 20% of its income will quickly see its replacement rate drop to 80%, even without considering planned lifestyle changes such as downsizing.
If you have a few years left until retirement, your savings rate may increase as your income increases.
Step 3: Subtract the tax deduction
Many people realize tax savings in retirement because they no longer pay Social Security or Medicare taxes. The resulting savings tend to be more pronounced for high-income earners than for low-income earners. Wealthier households may see a larger reduction in taxes in retirement than lower-income households because they have more control over their taxable income now that they no longer receive a paycheck. The less you withdraw from your portfolio, the less you will pay in taxes.
Step 4: Subtract the expected housing cost savings.
Housing costs are another item that can change significantly after retirement. For example, do you plan to retire without a mortgage? Or do you plan to relocate or downsize in some way? The main purpose of downsizing is to add the proceeds from the sale of your home to your retirement cat. Even so, it may have the beneficial effect of lowering your property taxes and reducing expenses such as insurance, utilities, and maintenance. Senior homeowners may be eligible for property tax exemptions depending on where they live.
Step 5: Consider lifestyle changes
Retirement planning guides often encourage retirees to take into account changes in other expenses, such as commuting costs, work attire, and eating out during or due to work commitments. For some households, these changes may be minimal, while for others they may be more significant.
Don’t assume your retirement-related expenses will go down without crunching the numbers. A heavier travel schedule, expensive hobbies or other expenses can offset cost savings on items like food.
Step 6: Increased medical costs
Healthcare is one of the key areas where retirees are likely to see increased spending. According to a recent study by Fidelity, the average lifetime out-of-pocket medical expenses for a 65-year-old retiring today will be nearly $160,000, and that number doesn’t even include long-term care costs.
The main factor behind what Blanchett calls the “smile on retirement spending” is the rising cost of medical care in later life. That is, household spending tends to be high immediately after retirement, decline in mid-retirement, and rise again toward the end of life as medical costs increase for some seniors. Without long-term care insurance, your household’s total health-related expenses can dramatically spike toward the end of your or your partner’s life.
Step 7: Add fudge elements
Taking each of these steps could bring you closer to your true replacement rate. At the same time, it’s worth approaching this exercise with the understanding that there’s a lot you can’t predict about future spending. Wildcards like long-term care costs, random home repairs, and support for adult children and family members can unexpectedly increase your retirement expenses. Because these unexpected expenses can occur, you may need to increase your replacement rate a little to give yourself some wiggle room in your planning.
This article was provided to The Associated Press by investment research website Morningstar. Christine Benz is Director of Personal Finance and Retirement Planning at Morningstar. For more personal finance content, visit https://www.Morningstar.com/personal-finance.
Related links:
Best Flexible Strategies for Retirement Income: https://www.Morningstar.com/retirement/best-flexible-strategies-retirement-income
3 Tough Decisions for Every Retirement Plan: https://www.Morningstar.com/personal-finance/3-tricky-decisions-every-retirement-plan
Your retirement checklist should be about more than financial: https://www.Morningstar.com/personal-finance/preparing-retirement-requires-more-than-financial-plan
Are you worried about nursing care costs? Let’s do something about it. https://www.Morningstar.com/retirement/youre-worried-about-long-term-care-expenses-lets-do-something-about-it
Copyright 2024 Associated Press. Unauthorized reproduction is prohibited. This material may not be published, broadcast, rewritten or redistributed without permission.
