If your current job security or satisfaction is in question, you may be considering whether retirement is an option. To determine whether you are financially able to retire, you need to thoroughly and accurately identify the amount of income you need to replace, the sources of income available to do so, and what additional assets you require to fill any income gap. This guide provides the important steps to answer these questions.
How Much Income Do You Need to Replace?
The first place to begin is determining how much income you need to replace to sustain your lifestyle in retirement.
People often approach this by adding up expenses such as your mortgage and other monthly expenses. We caution against this approach as it almost always excludes periodic expenses that quickly add up. These might include home and auto repairs, car purchases, new clothing, holiday spending, gifts, and travel among others.
Hence, we recommend examining your current income, how much you’re saving, and how much extra you might be spending. If you’re spending your full paycheck, then your take home pay equals your spending. If you’re saving extra from your paycheck, then you might be spending less. Conversely, if you’re accruing debt, you’re spending more than you’re earning.
The example below looks at how to account for those dollars to estimate your spending. This person brings home $120,000 per year ($10,000 per month). Of this net take-home pay, they set aside $10,000 for savings over the past year. However, they also accumulated $5,000 in credit card debt. At the end of the year, they spent $115,000 of their $120,000 income.
| You | Example | |||
| Your Current Net Take-Home Pay | $____________ | $120,000 | ||
| Less: Additional Savings | $____________ | -$10,000 | ||
| This does not include any employer retirement plan savings already deducted from your paycheck. |
||||
| Plus: Any Debt Accumulation | $____________ | +$5,000 | ||
| i.e., credit card debt, home equity borrowing | ||||
| Equals = Estimated Spending | $____________ | $115,000 |
Potential Changes in Spending
People often assume that spending will decline in retirement. However, we almost always see the opposite. Having more time on your hands for leisure, hobbies, entertainment, and travel frequently increases spending. It’s important to be realistic in your estimates.
Health Care Insurance
An important potential additional expense is health care insurance, particularly if you retire before you are eligible for Medicare at age 65. Health insurance is incredibly expensive, typically over $1,000 per person. In addition, the premiums increase as you age. Evaluate what either private health insurance or health insurance through the Healthcare Marketplace will cost as an additional monthly expense.
Income Sources
The next step is to determine your replacement income sources. These typically include Social Security and pension benefits. Key factors to consider in looking at benefit figures include:
Social Security
Review your Social Security benefits, including your potential benefits if you begin now versus delaying until your Full Retirement Age or later to age 70. Starting Social Security benefits at age 62 reduces your benefit by approximately 30% versus waiting until your Full Retirement Age, and by approximately 77% versus waiting until age 70. Up to 85% of your Social Security benefits, depending upon your income, will be subject to taxes.
Pension Income
If you are eligible to receive pension benefits, review the amount of your benefit, both if you start benefits now or defer until a later age. Can you afford to take a lower benefit for life? Also know if your pension benefit will increase with inflation, and what your benefit amount will be if you elect a survivor benefit for your spouse (which is highly recommended). Pension income is fully taxable as ordinary income with limited exceptions.
Review Your Assets
If your Social Security, pension or other retirement income benefits aren’t sufficient to replace your earnings in retirement, your savings will need to fill the income gap. Create a summary of your savings and investment accounts to calculate the total, then break out into four key categories:
Bank Balances
What are your current bank balances including checking, savings, and CDs? These are the most available assets to cover your immediate expenses without investment risk. It’s wise to hold adequate balances to cover your short-term expenses, but not so much that you forfeit the long-term investment growth you need. Taxable income from your bank accounts is limited to the interest you earn.
Retirement Accounts
What is the value of your retirement accounts such as your 401(k), 403(b), TSP, and IRA accounts? Additionally, withdrawals before the age of 59 ½ could be subject to a 10% penalty unless they qualify as an exemption.
Other Investment Accounts
Your other investment accounts represent those funded with after-tax dollars such as individual, joint, and Revocable Trust accounts. Assets in these accounts are available for withdrawal at any age. Taxes are only incurred as a result of investment income and realized capital gains when you sell assets.
Employer Stock and Deferred Compensation Plans
If you have investments in employer stock plans such as restricted stock units (RSUs), options, employer stock purchase plans (ESPP), or contributions you’ve made to a deferred compensation plan, you will need to make decisions about exercising shares, selling stocks, and tax impacts.
Annuities
Annuities you own might also be available to supplement your income. The various methods, such as converting the account to a lifetime income stream, need to be carefully evaluated relative to risk, inflation adjustments, and taxes.
Appropriate Investment Holdings
If you will need to begin taking account distributions, your accounts need to be positioned to hold lower-risk investments (i.e., bonds) to supplement withdrawals plus growth-oriented investments (i.e., stocks) to achieve the growth you need to sustain your long-term income needs, adjusted for inflation. Furthermore, the manner in which you allocate investments among your accounts should be carefully considered relative to which accounts you will be taking withdrawals from.
Taxes
As noted above, you will need to account for taxes when you calculate your possible retirement income sources. Just like when you were working, you only get to keep a portion of what you earn after paying taxes.
Liabilities
In addition to reviewing your assets, also take a careful look at your liabilities or debts. If you hold credit card balances, repayment of these balances and high interest rate charges should factor into your replacement income needs.
Lost Benefits
Depending upon your life and family circumstances, you might need to replace lost employment benefits such as life insurance. Replacement of such benefits will generate new costs.
Are You Ready?
In reviewing the above, there’s a lot to consider in determining if you’re financially prepared to retire. The decisions include how much income you need, what income will be available to you, do you have enough in savings, what will be lost to taxes, and do you hold the appropriate investments to protect and sustain you? Formal retirement planning helps to identify each of these questions and how they interrelate. If you haven’t recently developed and reviewed your long-term planning, this is the time before you make any retirement decisions.
SageVest Wealth Management reviews retirement planning on a recurring basis, ideally annual. Your planning guides your life and financial decisions. Not only does it answer if you can retire, but it also determines your appropriate investment positioning, savings, tax planning, asset protection, and more.
If you are contemplating retirement, please contact us to ensure you are adequately prepared and positioned to secure and enjoy your future.
