Am I going to run out of money, and die? Now, no one phrases it exactly like that, but that’s essentially what most of us are worried about, right. And it’s perfectly natural because we’re humans and that’s how we’re wired.
The biggest fear people have about retiring is running out of money, and becoming a burden to family and friends, or whoever feels they need to help support you.
Sometimes I meet with individuals or couples and they say, “Hey Tim, what’s our number? How much do we need to retire?” But it’s not about one number, because it’s always a function of cash flow. How much can you receive, after taxes, and how much are you going to need to spend to retire the way you would prefer?
So, I say, “Well, that number is different for everyone.” I could have one couple that has a nest egg of $5,000,000 but they’re spending $1,000,000 a year, so obviously, that won’t work for them over a 30-40+ year retirement. And on the flip side, I could have an individual with a $600,000 nest egg, and say they need $20,000 from their nest egg, in addition to what they will receive from their Social Security benefit, and with those two income sources, we can make that work.
Now, many people may have some arbitrary number of what they think they need in order to retire, maybe $1 million, maybe $3 million, maybe they’ve read somewhere that they need 10 times their current salary saved, and so on…
But it all comes back to the function of income and expenses. What can we have coming in, versus what’s going out.
Now, let’s break down those two variables, so you can better frame what you might need in order to retire comfortably and with peace of mind.
What Are Your Expenses? (or Cash Outflows)
Well, what do you want your retirement to look like? You want retirement to be enjoyable; you want it to be fulfilling. But think about what that is going to mean for you. Do you want to travel, play golf, volunteer and/or do you want to spend time with family? Many of my clients love spoiling their grandchildren.
Whatever you decide, now you can start to think how much that might cost.
And you can do this a couple of different ways: First, you can get very detailed, and accurate by simply writing down all your expenses per month, per year, and so on… or of course by using a budgeting app, Excel, or something along those lines. And then you add all of them up, then take out the ones you won’t have after you retire, and line by line, you get a very accurate picture of the expenses you will have in order to achieve your retirement goals.
The second way is not as accurate, but it is way less work and it can give you a high-level view of what your expenses might be once you retire: So how does that work? Well, you take your salary today but, your salary today probably has many deductions taken out of it, like maybe 401(k) contributions, or some other type of retirement account you're funding, probably payroll taxes taken out, probably withholding for income taxes, and so on.
This leads to a much smaller number actually hitting your bank account each month. So, the question is, what is that number? Because if you just want to maintain your current lifestyle in retirement, as far as expenditures go, that is, because you obviously won’t be working any longer, but let’s say you simply want to maintain your current lifestyle or something close to it. Well, this is good because we will just need to replace what your paycheck is delivering to your bank account, after all those deductions.
For example, and for simplicity sake, let's say you think you will need $10,000 per month to retire comfortably because your current salary is $10,000 per month or $120,000 per year.
So, intuitively you think you need to replace that $10,000 monthly, but you’ve been prudent, and you’ve been funding your retirement accounts with $2,000 per month. And now, you are retired, so you no longer need to fund retirement. So, we only need to replace $8,000 in monthly expenditures, not $10,000.
There are usually a few monthly cash outflows like this that you will no longer have in retirement. Maybe you pay off your mortgage the same year you retire, and this saves you another couple thousand dollars a month in expenditures. So, just like that, you’re down to needing $6,000 per month instead of $10,000.
Now you think about how retirement spending will be different based on what you want to do. Maybe you want to spend more on some of the things I mentioned earlier, like travel, golf, philanthropy, or maybe those grandkids, and let’s say that adds up to an additional $2,000 per month. Well, now you’re back up to $8,000 per month in spending, but that’s still lower than the $10,000 per month you thought you needed when you started this exercise.
And that, is a high-level and relatively quick way to see what your expenses might look like when you retire.
And keep in mind, at this point, you haven’t considered taxes. These are simply the expenses that you will have in order to retire the way you would like to.
Now, the second variable:
2: What Are Your Income Sources? (or Cash Inflows)
First, you start with income from sources like Social Security, income from pensions or annuities (which are similar), maybe some rental or farm income. Essentially, any income sources that you're going to have in retirement, excluding your investment accounts. Now, we add these up, and you have a general idea of your income inflows at this point.
Let’s say you’re married, and you will each have a Social Security benefit of $2,500 per person, for a total household income benefit of $5,000 monthly.
Now, continuing from our example earlier, let’s assume that your retired household living expenses will be $8,000 per month. Well, we know you will need $8,000 per month, and you have $5,000 coming from Social Security, so where are you going to get that additional $3,000 of income, to get to your goal of $8,000 per month?
Remember, this is about understanding income in retirement. Your tax rate in retirement is determined more by where you get the income (or cash inflows) from, as opposed to the income itself because of how our tax code works.
Because if you're receiving a pension or receiving some other income source, that's going to be reduced by taxes. So, we need to focus on the after-tax income that you'll receive.
Now, let’s assume we use the 4% rule, which is a popular retirement withdrawal strategy that suggests retirees can safely withdraw the amount equal to 4 percent of their savings during their retirement and have it last for 30+ years.
We use a dynamic guardrail withdraw strategy at my firm, which means it adapts to market fluctuations, so it pays a bit more than the 4% rule, but for this scenario, we’ll try to keep it as simple as possible.
Now, some simple math, if we know we need an additional $3,000 per month, or multiply that by 12 to get $36,000 per year, and we are using a 4% withdrawal strategy, we take $36,000 and divide that by .04 and that equals $900,000. So, taxes aside, you would need a nest egg of $900,000 to take $3,000 per month from, in addition to the $5,000 coming from Social Security to get to the $8,000 per month in desired income.
Now, we are interested in after-tax money that we get to spend how we want. But it is very important to note, that the type of account you’re holding your nest egg in, can have a large difference in tax liabilities.
Retirement Account Types
Let me give you a quick example of how account type can affect your retirement income. Now we have 3 account types we can invest with:
- Tax deferred accounts like 401(k)s, IRAs or any other pre-tax accounts. When we take money from these, it’s taxed at our regular ordinary income tax 7 bracket system.
- Taxable accounts like individual or joint brokerage accounts. These are taxed at the preferable long-term capital gains and qualified dividend rates.
- Tax-free or Roth IRA accounts, which grow tax free, and you can withdraw tax free, as long as your account has been open for at least five years.
So, let’s say all of our nest egg is in a pretax account, which is common these days, and our tax rate is 25%, and we still need $36,000 per year from this account. Well now we have to divide the $36,000 by .75 to account for what we will get to keep after taxes, and this equals $48,000 per year. Then we divide by .04 (because of the 4% rule), and now we have to have $1.2 million to get that same level of after tax income.
So, that’s a big difference from the $900,000 we thought we needed. But, if that $900,000 is in a Roth IRA account, then $900,000 is all we need, because we’ve already paid tax on this money and now it grows tax free.
So, at the end of the day, you want to make sure that you know your income and expense numbers, and realize how they will all be taxed, so that you can determine if you’re in a position, or not, to retire the way you want to.
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