Ready for retirement? How to calculate your income needs.

When preparing for retirement, estimating your annual income need can be a daunting task. Using this method, you should be able to calculate an estimate of your anticipated expenses in retirement that you can be confident in.

Torin Halsey/The Wichita Times-Record-News/AP/File
Retiree Jerry Hallman talks about water quality and the Colorado River Municipal Water District in Big Spring, Texas last month. Understanding your expenses today, and by extension, your expenses in retirement, is an essential piece of a successful retirement.

When trying to project your readiness for retirement, one of the most important factors to consider is your annual income need.  Estimating your income need, though, can be a daunting task.  Do you make a 100 line spreadsheet of everything you spend your money on?  While this may be the most accurate method, few people are willing to do it.  Do you use a generic shortcut such as simply using a percentage of your pre-retirement income?  It’s easy, but does it really represent your situation? If your goal is to be confident that you can retire, success starts with being confident about your spending needs.

When I work with my clients through the Financial Planning process, I use a combination micro / macro approach to create a good estimate of what my clients will spend in retirement.  Just as important, I review this calculation with clients annually to adjust for inevitable life changes.  Consider using this framework to estimate your expenses.

It may be easiest to look back at the year just completed, 2013.  Start with your Annual Gross Income (your salaries and bonuses).  From here, we subtract out many annualized items that will either go away in retirement, or be accounted for separately.  These items include, but are not limited to:

  1. Federal, State and Local Taxes Paid  (you can get this from your 2013 Tax Return)
  2. FICA Taxes (7.65% of you are a W2 employee under the wage base, otherwise check your W2)
  3. Paystub Deductions (Health Insurance, Union Dues, Pension, 401(k) Savings, Flexible Spending)
  4. Debts (Mortgage, Car Loan, Student Loans).  Make sure to only include Principal and Interest

This should leave you with the spending and saving number for your family for one year.  Subtract any additional saving that you do, like a Roth IRA or 529 Plan (saving money into an account for vacation that gets spent each year doesn’t count) and subtract any dependent care expenses (food, day care, schooling) and that leaves you with your “Base” Annual Expenses.  This is an excellent baseline for your retirement expenses.

Now you may want to make some adjustments to this “Base” number.  Will you take more vacations?  Want that second home?  Each of these numbers can be added in separately.

Of course, there is also healthcare you have to account for.  A study by Fidelity, further analyzed by Jester Financial, estimates that the cost of insurance today for a retiree is about $4,000 per person.  Consider adding another $1,500 or so for co-pays and co-insurance.

Now that we have your Adjusted “Base” Expenses and your estimated healthcare costs in today’s dollars we can apply inflation. I generally use 3% for my “base” expenses and 5% for healthcare.  After inflation, add back any fixed debts you may carry into retirement and factor in your expected tax rate to complete your estimate of your income needs during retirement.

This is an iterative process.  Your “Base” Expenses will change each and every year, not just from inflation but from pay raises, expense changes and general increases to your lifestyle. The further you are from retirement, the more this initial number may drift.   However, once you have this baseline, recalculating annually becomes much easier.

Understanding your expenses today, and by extension, your expenses in retirement, is an essential piece of your Financial Plan.  It’s too important to leave to a simply “Percentage of Income” calculation or to be ignored because its too hard. Using this method, you should be able to calculate an estimate of your anticipated expenses in retirement that you can be confident in.

Learn more about Mark on NerdWallet’s Ask an Advisor.

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