A general rule of thumb says that you will need
approximately 70-80 percent of your pre-retirement salary to live in
retirement. This line of thinking is based on the assumption that retirees will
have fewer expenses and, therefore, will need less money. Once you retire, you
will no longer be paying FICA taxes and contributing to 401(k)s and IRAs, and
making mortgage payments if your house is be paid off. But what you save in
these expenses can be replaced by spending on other expenses. Here are four
important often overlooked and underestimated retirement expenses:
* Free time. Many
individuals fail to factor in the amount of free time they will have in
retirement. When you are working eight hours a day, five days a week, you are
making money, not spending it. However once you retire, you now have an
additional 40 hours per week of free time to fill -- every week for the rest of
your life. That's a lot of time sitting around the house all day watching
television or reading a book. Without a job to go to, every day is like a
Saturday. You can go to the movies, have lunch or buy clothes. You can do
whatever you want. One could easily spend an extra $20 per day, which over the
course of a year is $5,000. If you originally planned on living on $50,000 a
year, spending an additional $5,000 would increase your living expenses by 10
percent.
* Unexpected
expenses. A new roof for your house. A busted water heater. A new
transmission for your car. Unexpected expenses don't stop happening just
because you retired. It is every bit as important to have a separate savings
(emergency) account earmarked for unexpected expenses in retirement, as it is
having when you are saving for retirement. Taking the money to pay for any
unexpected expenses from your retirement savings can significantly reduce how
much money you can spend on your everyday living expenses.
* Inflation.
Perhaps that's why one of the biggest retirement planning mistakes people make
is to forget to factor inflation in their retirement planning. Inflation can be
the silent killer in a retirement because it has the potential to erode your
savings and income over time. Inflation doesn't literally reduce the number of
dollars you will have in the future, but it does reduce your purchasing power.
At the historical average inflation rate of 3.5 percent, a person retiring
today on an annual income of $50,000 would need $60,000 of income to maintain
the same lifestyle in five years, and more than $70,000 in 10 years.
* Taxes. If all
or most of your money is in retirement plans (i.e., 401k and rollover IRAs), it
is important to factor in the role of taxes when determining your take-home
withdrawals from those accounts. Any income withdrawn from these accounts will
be taxed at your federal tax rate. For example, you have determined that you
will need $40,000 of annual income in retirement. You plan to have $1 million
in retirement savings and a 4 percent withdrawal rate will provide you with
$40,000. However, that amount doesn't include taxes. If you happen to be in a
25 percent tax bracket, you will pay $10,000 in taxes, reducing your annual
income to $30,000. To have $40,000 of after-tax income means you would need to
withdraw approximately $54,000 from your savings. This increases your withdrawal
rate from 4 percent to 5.4 percent, which can significantly increase your
chances of prematurely running out of money.
There is a big difference between living in retirement and
"living comfortably" in retirement. One of the biggest reason
retirees spend less money in retirement isn't because they want to live on less
money, it's because they have to. That's why it's important to consider all
potential expenses you may encounter in retirement. The more expenses you
include, the more reliable your planning will be.
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