How much can you afford to spend in retirement?

The rules of thumb for retirement are changing. A realistic look at your post-working age finances is required to truly know how much you need.

Melanie Stetson Freeman/The Christian Science Monitor/File
Alan Wardyga, a certified financial planner, holds the questionnaire he gave to the Powells as part of his financial analysis. A CFP will be able to better help you understand how you should spend during retirement.

You've finally reached retirement. Your days of fighting rush hour traffic to get to the office are over. But now you face a new challenge: How much of your retirement savings should you spend each year? It's a big question: Spend too much and you might find yourself out of money 10, 15, or 20 years into retirement.

"There are different ways to approach retirement spending," says Celandra Deane-Bess, chair of the national practice group on retirement for Philadelphia, Pennsylvania-based PNC Financial Services Group. "As you get closer to retirement age, we recommend that you take a more detailed look at your income and your living situation. There are so many factors that can alter how much you can afford to spend each year in retirement."

Planning your retirement spending isn't something you can do with a simple formula, though the following formulas can give you a starting point.

Inflation and the 60%–90% Rule

Deane-Bess says that many retirees plan for their annual cost of living, because of inflation, to rise 2% to 3% each year. That's a good starting point. But she also pointed to research showing that some costs of living are growing faster than the rate of inflation. This includes one of the major ones that impact retirees: health care costs.

Retirees will need to adjust that annual cost-of-living increase upward to account for the rise in healthcare costs, including the rising costs of prescription medications.

One rule of thumb that retirees have long followed is that they should spend from 60% to 90% of their after-tax annual income each year in retirement. So, if you were earning $50,000 each year before you retired and you had an effective tax rate of 15%, you were living on $42,500 after taxes each year.

If you decide that you need to spend 85% of your most recent after-tax yearly income in retirement, you'd need to have $36,125 available to you each year after retirement. You can generate that yearly income from your savings, pensions, Social Security, and any other regular streams of income you might have.

Again, though, this is only a general rule of thumb. You can change how much of your pre-retirement income you'll actually need during your retirement years, Deane-Bess said. If you move to a less expensive home or community, for example, you might need to spend 60% of your pre-retirement income each year. If you live in a higher-cost area, you might need to spend the full 90% each year.

The 4% Rule

Another rule of thumb? The 4% rule. This rule says that you should withdraw 4% of your retirement-savings portfolio in the first year of retirement for your living expenses. You should then withdraw that same dollar amount, plus enough extra income to account for inflation, every other year of retirement.

It's important to note, though, that this formula rests on the assumption that your retirement will last 30 years. If you're particularly healthy, and you might be retired for more than three decades, you might have to withdraw fewer dollars each year to make your money last.

Expect Some Expenses to Rise

"People often forget that there are actually a few expenses in retirement that go up," Deane-Bess says. "Everyone assumes that their expenses will go down in retirement. But not all of them do."

For instance, if you are going to be home more often after retirement, your utility bills will typically rise. That's because your heat will be on all day and you'll be using more electricity because you'll be home more often.

Some retirees also spend more on leisure, entertainment, or travel during their after-work years. Instead of taking one big trip a year, they might plan on taking two or three. They might take more frequent smaller trips to see their grandchildren.

The takeaway? You need to look at your own retirement plans — where you'll be living, what you'll be doing — when deciding how much money you can afford to spend each year. Start with the rules of thumb, but tweak them to meet your needs.

For instance, Deane-Bess said that retirees who want to travel frequently or live in a higher-cost community might need to withdraw just 2.5% to 3% of their savings portfolio every year.

"We are starting to see a pullback from some of the rules of thumb," Deane-Bess says. "I have been in the industry for 18 years. When I started, there were lots of rules of thumb. But things are changing. Today, it's about taking a more detailed look at your individual retirement plans."

This article first appeared at Wise Bread.

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