In planning for retirement, you need target numbers. Numbers such as how much money you’ll need to have saved by the time you retire, how much you’ll have to contribute each year in order to reach that goal, and how much you’ll have to earn on your money between now and then. But before you can establish any of those numbers, you first need to determine how much money you’ll need to live in retirement. Only when you have that number can you know if all the other numbers will even be valid.
So in this article, we’re going to discuss methods to calculate how much income you will need when you retire. We will look at a percentage method, as well as some non-percentage methods that are likely to be much more accurate.
The Standard Percentage Convention: 80% of Pre-retirement Income
For simplicity’s sake, people prefer reducing a complicated calculation, like retirement income projections, to a simple percentage. “Forget about crunching numbers - just give me a target percentage.”
Fair enough. And the retirement planning industry has done just that. It’s generally about 80% of your preretirement income - some sources will go higher, at 85%. In the absence of a more detailed analysis, it’s probably a solid convention. It gives you a target number for planning purposes and makes the very realistic assumption that you’ll need somewhat less income in retirement than you do during your working years.
It’s probably an outstanding convention to use early in life when it’s not possible to know what your pre-retirement income will be or even your specific living expenses.
The disadvantage of using a single percentage, however, is that it won’t apply in a lot of cases, or even most of them. Everyone’s situation is different, and for that reason, one-size-fits-all will probably be no more than a gross oversimplification.
Here's an example...
It’s Different for High-Income Earners
High-income earners are often able to save a larger percentage of their incomes than middle and lower-class households. They are also almost always in a higher income tax bracket. For high-income earners, using 80% of preretirement income will probably be far too high.
In How Much Income Do Retirees Really Need? Michael Finke notes the following:
“When we plot out median spending as a percentage of gross income among pre-retirees, we see that those in the middle, fourth, and especially the fifth quintile of income aren’t spending anywhere close to their income. In fact, the median household in the top income quintile is spending 36% of their gross income each year. Even the 90th percentile spendthrift in the top income quintile is spending just 63%.”
Where retirement income planning is concerned, high-income earners have two advantages:
- They actually live on a lower - sometimes much lower - percentage of gross income than middle and lower-income households, and...
- They save a higher percentage of their incomes, increasing their ability to accumulate very large retirement savings portfolios.
And since there can be such a large variation in the incomes of high-income earners, the actual percentage of income that they will need to replace in retirement will depend upon individual circumstances. Thus, it is too wide for a standard convention. As noted in the quote from Michael Finke above, the percentage can range anywhere from 36% to 63% of gross income.
Using a percentage of pre-retirement income method to estimate how much income you need in retirement is a decent approximation, particularly absent a more detailed calculation. It's certainly better than nothing, but it's also less-than-perfect.
Let's take a look at some non-percentage methods to calculate needed retirement income.
Using Pre-Retirement After-tax Income
This is another simple - but not perfect - way to calculate retirement income needs, but one that uses actual numbers. For example, if you earn $100,000, and pay $20,000 in income taxes, you're after-tax income is $80,000. If that is roughly what you actually spend each year, that may be a valid retirement income estimate.
Its strengths are that it's very easy to use and will likely be at least a reasonable estimate for a large number of people.
The weaknesses are that 1) you will likely still have income taxes to pay once you retire, particularly if you're high income, 2) it won't be a valid estimate if you are many years away from retirement, and 3) it will be virtually useless if your after-tax income bears no resemblance to what you actually need to live on.
If you are many years away from retirement, you will have to do an income projection to account for the higher income that you will likely be earning just before you retire. For example, if you’re 35 years old and have an after-tax income of $50,000 per year, and hope to retire at age 65, you’ll have to project what your net income will be 30 years from now.
If you assume that you will experience an average annual increase in salary of 3%, you can determine that your after-tax income will rise to $121,364 by the time you're approaching your 65th birthday.
Using Actual Living Expenses
This will result in a much more specific retirement income projection. Rather than using a simple percentage, or your after-tax income, you actually calculate what your current expenses are.
There are two ways you can do this:
Compile your actual annual living expenses - That means going through your checkbook, bank statements, and credit card statements to determine how much money you spent. If you want to be really accurate, analyze your expenses for the past two or three years, and then use an average. That will reduce the likelihood that you will be basing your all-important retirement income projection on a number that is either unusually high or unusually low.
Calculate your annual living expenses by removing non-living expenses from your income - Rather than analyzing expenses, which is admittedly a tedious process, you start with your annual income and then deduct non-living expenses, such as income taxes, retirement contributions, and non-retirement savings contributions. The net result should be the actual amount of money spent in the course of the year. Once again, this is best done over a two or three-year period.
Using Any of the Above Methods With Adjustments for Changes in Lifestyle and Spending Patterns
Whatever method you use to determine how much income you need in retirement, will be just a starting point. You’ll also need to adjust for predictable changes in lifestyle and spending patterns.
For example, if you expect to have your mortgage paid off and your kid’s education done and paid for by the time you retire, you can subtract those expenses from your retirement income estimate. You should also make a reasonable estimate of a reduction in expenses that might result from downsizing your home or moving to a low-cost or low-tax state. And if you want to get really technical, deduct work-related expenses, such as commuting expenses, daily lunches, and dry cleaning.
At the opposite end of the spectrum, you have to make upward adjustments if you plan to purchase a second home or a boat, or if your retirement plans include significant travel.
And to the degree that it’s possible, you should make reasonable predictions about your income tax situation. For example, if you expect to have abundant retirement income, higher income taxes are a possibility. That’s not just because of high income either. The absence of exemptions for your children and the mortgage interest deduction can combine with a higher income to produce a surprisingly high tax liability. Having worked in CPA firms for many years, I can tell you that this is not as uncommon as you might think.
If you expect your retirement income to be on the more moderate side, income taxes may not be a factor at all. This will be especially true if you live in - or plan to live in - a state that either has no income tax or has very generous exemptions for retirement income.
This will be a topic best discussed with your tax accountant, who may have to answer the question by providing a detailed income tax projection.
Don't Forget to Figure Third-Party Retirement Income into Your Calculations
Fortunately, there is some relief available no matter which retirement income estimate method you use. Any retirement income number you calculate can be reduced by the amount of third-party retirement income that you expect to receive.
This starts with Social Security income. You can get a solid approximation of your Social Security retirement benefits by using the Social Security Benefits Estimator. You can then deduct your annual benefit amount from your retirement income number.
You can do the same with a defined benefit pension plan benefit if you are one of the fortunate few who still have this benefit available. You can usually get an approximation of your pension benefit through your human resources department. But be careful here unless there is a very high likelihood that you will remain employed in the same job between now and retirement, you may not want to factor this number into the mix. A layoff at an inconvenient time could put an end (or a serious reduction) to this benefit. It might even be best to think of it as bonus income.
It would be great to say “Here’s the percentage you need to calculate your retirement income - have at it,” but it will be nothing more than a very loose estimate. If you want something more specific, and probably more reliable, you’re going to have to crunch some numbers.
Have fun with it, but remember that it will never be better than a loose estimate. But even that’s better than nothing!