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The exact amount you’ll need to enjoy retirement depends on factors like your existing savings and available resources, current debt, cost of living, retirement goals, and more. According to a study by Charles Schwab, people think their “magic number” for retirement is $1.8 million.
Reality, however, paints a different picture. The average amount of retirement savings per household is actually around $331,400, meaning most Americans have quite a ways to go to meet the “ideal” retirement savings goal.
To determine the effectiveness of your retirement savings strategy, you’ll need to consider your future expenses, income needs, and retirement resources.
Key Takeaways
- Your retirement expenses will vary depending on which stage of retirement you’re in.
- The 4% rule is one method for determining how much to withdraw annually, but its effectiveness is debated amongst professionals.
- Understanding your retirement income resources is an important first step in building out a tax-efficient and sustainable income strategy.
- You may need to adjust certain lifestyle spending habits or retirement timeline expectations to ensure your retirement resources last.
Understanding Retirement Expenses
While it’s impossible to predict the future with certainty, it is important to consider what expenses you’ll likely incur throughout retirement. You can use some well-known formulas, calculators, or other methods for calculating your predicted retirement costs. These take into account both your personal circumstances (savings so far, current savings rate, timeline, and other factors) as well as macroeconomic data, like stock market history and average life expectancy, to deliver data-driven estimates tailored to your circumstances.
Estimating Future Costs
One of the most straightforward retirement cost formulas is the 80% rule. Expect to spend around 80% of your pre-retirement income during retirement.
If you earn $100,000 in your final working years, for example, you’ll need around $80,000 annually in retirement.
Why not 100%? Once someone transitions into retirement, they tend to spend less on expenses like commuting to work, buying clothes, supporting children financially, and contributing to retirement savings. In fact, Fidelity used national spending data to determine that retirees spend between 55% and 80% of their pre-retirement income on average.
Phases of Retirement Spending
Generally speaking, average spending will vary year by year in retirement, just as it does during your working years.
Most people in retirement experience three phases, which correlate directly with their spending habits:
- Early retirement: Active years with the highest levels of spending.
- Middle retirement: Slowing down and spending less.
- Late retirement: Staying close to home means spending the least amount of money, but health care costs could rise.
While people will statistically spend more on health care later in life, they still tend to spend the most money during their first few years of retirement. These expenses are often attributed to more travel, entertainment and recreation, and caring for aging parents. By comparison, those who are 75 and older gradually reduce their spending on things like new clothing, entertainment, food, and travel.
But again, those in the later stage of retirement are more likely to be diagnosed with chronic illnesses and require ongoing medical treatment or long-term care. These can push the costs of retirement up significantly, depending on an individual’s insurance coverage and health status
Calculating Retirement Income Needs
With an understanding of how much you might expect to spend in retirement, the next piece of the puzzle is determining which income sources you’ll withdraw from and when.
The 4% Rule
The 4% rule dictates that a retiree can safely withdraw 4% of their portfolio annually (adjusted for inflation) without running the risk of depleting their portfolio. For example, if you entered retirement with a portfolio worth $2 million, you would withdraw $80,000 your first year in retirement. After that, you would withdraw another $80,000 with an inflation adjustment. If inflation was 3%, you would then withdraw $82,400. The process is repeated every year.
That being said, the 4% rule relies on several important assumptions, which don’t always apply to today’s retirees.
First, the 4% rule is based on a 30-year retirement. If you plan on retiring early or come from a long line of centenarians, the rule may not work. Another concern? The 4% rule changes to accommodate rising inflation, but does not take into account market performance or fluctuations in your annual spending habits.
Warning
While the 4% rule is perhaps the most widely recognized withdrawal formula, its effectiveness has come under scrutiny by large financial institutions and economists in recent years.
This rule may be a good place to start, but more precise retirement income strategizing may be needed to ensure you’re following a safe and sustainable withdrawal rate.
Income Sources in Retirement
During your working years, your income sources were likely limited to what you earned from working, though you may have received some investment income as well from rental properties or dividends.
But in retirement, you’re in control of building your retirement paycheck—and that means determining which income sources are at your disposal, how they’re taxed, and when to withdraw.
Some sources of income will be fixed, meaning you have guaranteed access to them for life. Social Security is the most common form of fixed income for retirees, though some government workers may have access to a pension as well. Social Security is especially important since it’s adjusted for inflation annually.
Other common sources of retirement income include:
- 401(k), 403(b), or IRA
- Roth IRA or Roth 401(k)
- Health savings accounts
- Brokerage account
- Personal savings
- Annuities
- Proceeds from the sale of your business (for business owners)
Strategies for Ensuring Adequate Retirement Income
One of the biggest concerns most people have entering retirement is, “Will I have enough?” Here are a few strategies for building up your retirement income ahead of time and minimizing the risk of running out of funds during retirement.
Increase Savings
If you’ve run the numbers and believe there may be a gap between your existing savings and how much you’ll need to enjoy retirement, one simple solution is to increase your savings. The earlier you’re able to do this, the more you’ll be able to benefit from the advantages of time and compounding earnings.
Tip
If you aren’t already maxing out contributions to your retirement savings accounts (like a 401(k) or IRA) and Roth accounts, consider doing so if it’s feasible.
Another option, which may be less than ideal, is to adjust your retirement timeline and continue working for longer. Doing so would enable you to continue growing your savings and delay your initial withdrawal.
If the markets are performing poorly right as you’re considering retirement, delaying could also help you avoid the corrosive effects of a market downturn. Called the sequence of return risk, the sooner a market downturn happens in retirement, the greater the impact it will have on your portfolio’s longevity.
Adjust Lifestyle and Expenses
In order to increase your retirement savings, you may need to make changes to your spending habits and general lifestyle. Take a look at your expenses over the past few months and consider where your discretionary income is going. What expenses could you reasonably cut back on in order to boost your savings?
You may need to reconsider how often you eat out at restaurants, take vacations, or shop. If you find your monthly cost of living is too high or you feel like your family home has become a big empty nest, you may even consider downsizing your living space to save on expenses.
Plan for Uncertainties
As much as you can prepare for retirement, you simply can’t predict what’s going to happen in the coming years (or decades). Consider how certain macroeconomic events, such as a recession, market decline, or global financial crisis, could impact your portfolio and savings. Your personal circumstances could change as well. You may need to take a year off work to care for an aging loved one, experience a medical emergency that results in medical debt, or otherwise incur unexpected debt and expenses.
Create a contingency plan for addressing unexpected shortfalls in your retirement income. An emergency fund, for example, can be useful for covering unexpected expenses without disrupting your long-term savings strategy. You may also want to review your options for generating guaranteed or steady income in retirement, such as an annuity, a whole life insurance policy with a cash value, or bonds.
What Are Some Unexpected Expenses That Retirees Often Overlook?
Retirees tend to underestimate the cost of pursuing new hobbies and entertainment early on in retirement. They also overlook health care-related expenses that may not be covered by Medicare or insurance, including long-term care and home modifications.
How Can Inflation Impact Retirement Income and Expenses?
As inflation rises, it puts a strain on retirees’ resources, particularly those who don’t receive a cost-of-living adjustment. Traditional strategies, like the 4% rule, may no longer offer a safe and effective withdrawal rate. Since most retirees maintain a fairly conservative portfolio, their assets may struggle to maintain or exceed rising inflation rates—particularly during years of high inflation or market volatility. The cost of goods and services gradually increases over time as well due to inflation, which can further strain a retiree’s resources.
How Can Retirees Manage Health Care Costs Effectively?
The key to managing health care costs in retirement is to prepare for whatever medical emergencies or changes in health may arise over time. Retirees can establish a health care emergency fund using a tax-advantaged health savings account (HSA) or a high-yield savings account. They may also want to consider obtaining supplemental insurance policies to address concerns that lie outside traditional Medicare coverage, such as long-term care.
The Bottom Line
Creating retirement income and developing a sustainable withdrawal strategy takes time and careful planning. Over decades, you should be considering what small steps you can take to set yourself up for a more secure and comfortable retirement in the future. Then, as retirement approaches, use a retirement income formula or calculator to determine how much you’ll need and what you can safely withdraw annually to support your needs.
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