Most financial advisors will start by encouraging you to use a rule of thumb that is quite popular like "when you retire, you will need to have 75% of your total pre-retirement income." However, who is to say whether this rule of thumb is going to actually hold true for your personal circumstances. Different people will have various retirement plans, and it makes sense that these various plans will have different price tags attached to them.
Briefly put, unless you happen to be comfortable with the concept of searching for work after being retired for several years, then there isn't any another viable option other than to sit down and calculate the amount of money you will need in your retirement.
How To Calculate Your Expenses
Fortunately, it is isn't as hard to make these calculations as you may believe. You can get the job done with a simple, two-step process:
First, determine what your current expenses are.
Second, make your best estimates on how your expenses will change over time.
In order to get the most accurate figure for your current expenses, make sure you review an entire year instead of just a couple of months. It does take more work, however, it will help to prevent you from forgetting about expenses that you pay just once a year, like annual vacations or some insurance premiums.
To calculate what your expenses were over the past year, there are three things that you are going to need: your paycheck stubs (to understand expenses such as insurance that were directly deducted from your wages), bank statements and credit card statements.
After your expenses from last year have been tallied up, do your best to make adjustments for things that are going to change after you retire. For instance:
Saving for retirement: One you have retired, you won't be saving for it anymore.
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Mortgage payment: Once your mortgage is completely paid off, you won't have this payment to make any more.
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Work-related expenses (for instance, commuting and dry cleaning costs) will disappear for the most part.
Health insurance premiums: How are they going to change as you grow older, and as you stop having coverage through work, and start being eligible for Medicare instead?
Entertainment costs: Are you planning on traveling the world, or are you anticipating spending some of your time on a hobby that could perhaps bring in some income for you?
Of course, a majority of the figures are going to be estimated. That is perfectly fine. You don't need to have an exact, down-to-the-last-cent budget. Any estimate that is based on your needs and goals will be more accurate than using an amount that you got from following a rule of thumb guideline.
How To Adjust For Inflation
If you won't be retiring for many years, it is very important to revisit your spending-tracking exercise regularly (for instance, every 2 to 3 years). This way you can update your planning figures to account for lifestyle changes as well as inflation that have taken place since your last estimates were made.
Make Sure To Adjust For Taxes
Because of taxes, you will need to have a higher amount of yearly income in order to cover all of your annual expenses.
Social Security, Pensions, and Other Forms of Income
When you are determining whether or not you have saved enough for your retirement, your goal isn't to figure out how much money you need every year, but instead how much income is needed every year from your investment portfolio. In order to arrive at this figure, deduct any other income you are expecting to receive such as from a part-time job, pension income and Social Security benefits.
If you are at least 60 years old, you should be receiving a Social Security statement every year that provides you with an estimate of what your expected Social Security benefits are going to be. If you are younger than 60 years old (or you are unable to locate your paper statement), the information can be found online at ssa.gov/myaccount/
Planning strategies for Social Security are beyond the scope of this article, however, it is important to point out that deciding when to start receiving your Social Security benefits is definitely something you should seriously consider. Depending on what your circumstances are, the best thing for you to do might be to start receiving your benefits just as soon as you are eligible for them. On the other hand, it might be best for you to wait as long as possible. Or perhaps it would be beneficial for you to utilize more advanced strategies like claiming spousal benefits when you reach full retirement age and then wait to claim your own retirement benefits when you reach the age of 70.
Basic Summary
When it comes to retirement planning, the first step that you need to take is to estimate the amount of income you are going to need on a yearly basis for your retirement.
When you are calculating what your annual expenses are, make sure to review a full year of data to ensure that you don't overlook any expenses that you pay just once a year.
When determining how much income you are going to need from your investment portfolio, don't forget to account for the income taxes you will have to pay.
When you are calculating the amount of income you are going to need from your investments, don't forget to subtract any income you are expecting to get from other sources like Social Security and pensions.
As your time to retire gets closer, it is definitely worth revisiting your calculations. An estimate of what your expenses will be one year before you retire is going to be a lot more useful than information from ten years before you retire.
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