Alright alright alright, welcome back to the indeterminate length series on the 4% Rule! Confused about what I’m talking about? No worries. Just head over to this post for a few minutes and we’ll meet you back here in a bit.
Okay. Now that we’re all caught up on the introduction to the 4% rule, I want to address the first thing I see people getting wrong when they are figuring out their retirement income needs. And I’m not even going to go into one of the really difficult, weighty issues like how to account for healthcare or whether they should plan for Social Security or if 4% is really safe. Those are really important things to think about, we just aren’t at that advanced of a point yet.
Instead, I want to start at something simple. One of the basic building blocks of personal finance. The one everybody hates talking about.
More specifically, how your retirement budget will determine the amount of money you need in your retirement portfolio* using the 4% Rule.
I know, I know. Budgets are the worst (no they aren’t). But trying to figure out your retirement goals without understanding what your expenses will be is like trying to hit a target with your eyes closed.
In the Introduction to the 4% Rule post, I said I’d show you how to calculate the income you will need in retirement. It’s really easy. Ready?
Write a retirement budget, add up the total, and multiply by 25.
Boom! According to the 4% Rule, that’s how much money you need!*
Yes, it really is that simple.* You see, if you believe the 4% Safe Withdrawal Rate really is safe, then you need to build up a retirement portfolio* that will give you the income that you need in the first year by taking out 4%.
To determine that, the key number in today’s post is 25. Why? Because 100% (1) divided by 4% (.04) is 25.
1 / .04 = 25
Okay, so how do you determine a retirement budget?
You might be thinking to yourself “how the heck am I supposed to write a retirement budget? That’s way too far into the future!”
No worries, it doesn’t have to be perfect. In fact, the farther away from retirement you are, the less accurate it needs to be. You don’t want to completely make stuff up, so treat this process seriously. Putting down ridiculous numbers will just end up giving you a ridiculous result. But it doesn’t have to be perfect. As you get closer to retirement, you should continue refining your retirement budget and make sure it’s in line with how your portfolio is growing.
Estimate your retirement spending
Take some time to imagine what you want retirement to look like. Where will you live? How much will you travel? What will you spend your time doing?
When you do this estimate, just use current day dollars. Accounting for inflation comes later.
You can also use your current lifestyle as a guide. If you are already happy with your lifestyle, your budget will look fairly similar. If you think you will be spending more or less in retirement, adjust accordingly.
Start by taking a stab at what your required monthly expenses will be. You can use this worksheet from Vanguard as a guide. At a minimum, you will want to account for:
- Housing (include mortgage/rent, property taxes, insurance, and utility costs)
- Insurance (health/dental (or self-funded care) as well as life and long term care, as needed)
- Transportation (car, maintenance, gas, insurance)
- Debt payments (although ideally you go into retirement debt free!)
Next, add up your discretionary expenses
- Personal care
- Gifts and charity
- Et cetera
Finally, add all of the non-regular expenses that come up throughout the year or once every few years. Things like insurance premiums (if you don’t pay them monthly), car registration, house repairs, etc.
Now fix that budget
Go back and put a really critical eye on things that will be different in retirement. Will you spend more on travel? Less on transportation because you don’t have to commute?
Have you really accounted for healthcare costs? Remember, they can rise rapidly later in life. Maybe add a little more to this category. Talk to your parents and/or grandparents to get a good idea of possible costs.. And consider whether you will want to pay for long term care insurance. That’s something I’m thinking through right now.
Don’t forget taxes!
You need to account for taxes, too. Pensions, tax-advantaged retirement accounts, taxable accounts, real estate, etc all use different tax rules…you need to think about the tax implications for each.
If your retirement income will come solely from a pension or similar predictable source (such as an annuity), your taxes should be very easy to figure out. If you will also be using other sources of income, you might need to do a little more work.
There are three things you can do to estimate your taxes. You can:
- figure out the tax rules for each of the different sources of income and calculate the total taxes you’ll owe based on that
- use a conservative estimate (like 25%)
- use the IRS Withholding calculator to make an educated guess
Personally, I’d go with a combination of the second and third options. The first option is going to be difficult for most people to do until they are within a couple of years of retirement, unless they manage to have 100% of their retirement portfolio in Roth accounts, Social Security, or otherwise untaxed systems.
The way I do it is to start with a flat tax rate, then refine it with the withholding calculator. For instance, I know from years of tracking expenses and imagining what I’d want my life to look like in retirement that I want to spend roughly $3400/month. That’s $40,800/year in after-tax spending. Having a general idea of the tax brackets, I know that means the majority of my income would be in the 15% bracket if it were all regular income. A small amount would be in the 10% bracket, and an even smaller amount in the 25% bracket. So for years I’ve estimated that I will pay about 20% in taxes in retirement. That means I would need approximately $51,000 in income – 20% in taxes ($10,200) and 80% leftover for spending ($40,800).
If you need an easy equation to figure this out, here it is. Take your estimated after-tax spending and divide it by (1 minus your estimated tax rate). So for me, it’s $40,800 divided by (1 minus 20%). That looks like:
$40,800 / (1-0.2)
$40,800 / 0.8 = $51,000
Why do I project my taxes as if they will come from regular income? Because it’s the most conservative way I know of to do it. The results may not end up being perfectly accurate, but any inaccuracies are in my favor. That’s because regular income (including pensions and Traditional retirement accounts) is taxed the most of the normal retirement income sources. Roth investments, Social Security, some annuities, taxable accounts, etc will usually end up being taxed at lower rates, if at all. So planning for all of my retirement income to be taxed as regular income means at worst I will have the spending money I expect. At best, I will have more spending money than expected because my taxes will be lower than expected!
Okay, back to how I do this. So far I’ve estimated my tax burden will be 20%. I then used the tax withholding calculator to actually run the numbers. When I published my projected retirement budget a few months ago, I found out that my actual tax burden, using 2017 tax rules, was 11.5% ($5870 instead of $10,200). That’s because even though I’d be in the 25% tax bracket, the combination of deductions, exemptions, and graduated brackets means nobody actually pays a full 25% (or whatever bracket they are in).
And yes, that’s based on 2017 rules. What it looks like in the future is still being reconciled in Congress.
What does this have to do with the 4% Rule?
Now that you have a few ideas of how to determine your taxes in retirement (you can also look here for more info), add up your spending plus estimated taxes to arrive at your gross income needs. If you expect $40,000 in spending and $10,000 in taxes, your gross income annual need is $50,000.
Multiply that amount by 25, and voila! You have the amount you need in your retirement portfolio* to meet your income needs using the 4% Rule.
$50,000 times 25 = $1,250,000
Don’t let that number get you down. I know it looks like I am telling you you need an enormous amount of money in your investment accounts to live a middle class life. And if you want to spend more than this in retirement, your number would start getting huge!
Many people see their number and stop there. It either becomes the goal, or they give up. That’s one of the biggest mistakes I see people make in retirement planning.
I promise, there is more to this process than that. Especially if you are looking at getting a military or other kind of pension! Next time, I’m going to show you why many people don’t actually need that much money in an investment account to be able to use the 4% rule.
*Except it’s not necessarily really the amount of money you need in your retirement portfolio. Repeat this to yourself: “retirement portfolio is not the same thing as investment account.”
Your homework assignment: over the next two weeks, build a draft retirement budget and figure out what your portfolio number needs to be. Keep it handy – we’ll be talking about it again. See you on Sunday!
Gentle Reminder: I am not a financial advisor. I have never been a financial advisor. I will probably never be a financial advisor. I like talking about money. You should probably talk about money with a financial advisor before taking advice from someone on the internet.