This article is part two in a series, the previous article looked at three questions to help focus on the non-monetary goals in retirement. Essentially to find what is most valuable in the life of a future retiree. This article helps answer the important money questions for a financially prosperous retirement.
Annual Spending: Start with the Basics
In determining a retirement budget, start by looking at annual spending for the past year or two. Including every household expense and account for all cash spending, credit card purchases, and debt payments. Cutting easily eliminated expenses will help reduce future retirement spending. More closely tracking spending, also leads most people to spend less. After making these changes a future retiree may find their total annual household spending is $50,000. They now have a baseline budget, but this amount is only the beginning.
Annual Spending: Taxes, Inflation, and Replacement Costs
This initial $50,000 annual budget may cover household expenses this year but it is missing some important factors. And this is where many retirees get into trouble; they forget to include taxes, replacement costs or major repairs, and cost of living increases. Let's look at these topics in more detail.
Taxes: Most retirement income will be taxed at the Federal and possibly the State level. Income from common retirement accounts like a 401k or a traditional IRA is taxed as ordinary income. Dividends from stocks and interest from bonds will also be taxed unless they are in a Roth IRA. Also up to 85% of Social Security Retirement Benefits may be taxable, depending on a retirees total income and filing status. Future retirees need to anticipate these taxes to ensure their after tax income can cover their annual spending.
Inflation: Annual retirement income also need to increase to account for inflation. A budget of $50,000 this year may require $52,000 next year to maintain the same lifestyle. However there will also be periods, as we are seeing now, when inflation will spike even higher. This has been an unpleasant surprise for many retirees who saw the purchasing power of their income fall dramatically. Creating a diverse retirement portfolio with adequate stock holdings can help ensure retirees have enough retirement income to keep pace with rising inflation. At a minimum, assume an annual 3-4% budget increase for inflation.
Replacement Costs: This next factor is often the Achilles Heel for retirees. Retirees must budget for periodic replacement costs such as replacing a vehicle, painting a home, replacing a roof, or buying new appliances like refrigerators and washing machines. Many retirees forget to include these major expenses.
Prudent retirees set aside an additional 10-15% of their retirement budget for these replacement expenses. For example, a retiree with an annual $50,000 starting budget should have a separate annual replacement expenses budget of $6,000 kept in a high yield savings account. Similar to the regular retirement budget, a replacement budget also needs to increase as inflation rises. These savings will help prevent unpleasant surprises in retirement when major expenses come along.
Strategies to Stretch Retirement Budgets
There are a few ways to help stretch retirement budgets, but they require proper planning in the pre-retirement years.
Debt Reduction: Soon-to-be retirees can dramatically reduce annual expenses by paying off all debt. Eliminating any credit card debt and paying off a mortgage prior to retirement significantly lowers annual expenses. The savings can be 20% or more of annual expenses and provide a valuable cushion in retirement.
Pay Replacement Costs Now: To reduce future replacement costs take care of these expenses just prior to retirement. Repainting a home, purchasing a reliable vehicle, and replacing an old HVAC system just prior to retirement can significantly reduce future retirement expenses.
Extra Income: One of the best ways to ensure adequate funds in retirement is by adding a small income stream. This can be from side hustles, a small business, or an enjoyable hobby that generates a return. Earning just $500 per month can add an additional $6,000 a year to retirement savings. If this income is saved in a Roth IRA there is the added benefit that the future income it generates is tax free.
For more ideas to prepare for a successful retirement consider these eight questions as well as strategies for withdrawing funds in retirement. Also consider focusing on where savings are invested instead of the size of a retirement portfolio. For a complete guide to retirement planning and securing financial freedom see Become Loaded for Life.