5 Retirement Planning Topics That Need Clarification

There seems to be a never ending supply of articles offering advice about retirement planning. Some offer well thought out points, some offer generic assumptions, some offer half-truths, and some don't seem to have much to offer at all. The five topics listed below address some areas that might benefit from a little extra clarification.

The Assumption That You'll Need To Replace 75% Of Your Salary In Retirement. Many articles suggest that you should plan on replacing 70% - 80% of your salary in retirement, so I split the difference. In very general terms, with a salary of $75,000 per year, you may have 18% in Federal and State taxes ($13,500) deducted from your paycheck, and another 15% ($11,250) may be deducted pre-tax for items such as employer sponsored health care, 401k savings, health care spending accounts, or other elective deductions. This leaves a take-home amount of $50,250 per year. Let's assume that $2,250 of that (for the sake of round numbers) is earmarked for general, college, emergency, or other savings. This means that you are living on $48,000 per year. If your expenses stayed perfectly constant throughout retirement (they won't), you budgeted perfectly and spent your last penny on the day you died (you won't), and you knew that you would die in exactly 25 years (not likely), you would need $1.2M in savings to get through retirement. Almost. Actually, it would be closer to $1.35M because you would need approximately $135,000 to pay for taxes on your annual withdrawals.

However, you are very likely to be eligible for Social Security benefits. The average benefit is approximately $1,300 per month, and a non-working spouse (who is not eligible for their own benefit) is eligible for 50% of their spouse's benefit. This would provide a one earner household with income of $23,400 per year ($1,950/month), or $19,450 per year after taxes (yes, social security income is usually taxed, but uses a different schedule then ordinary income tax). This means that you would need $28,550 per year from savings to pay your expenses of $48,000 ($48,000 - $19,450), or a total of $713,750 over 25 years ($795,000 including taxes on savings withdrawals). That's a lot less than the $1.35M stated above, and only 42.4% of your $75,000 salary.

This is a very simplistic example, with a lot more details that could be considered, but believing that you will need savings that will replace 75% of your salary in retirement is most likely misleading. It is certainly wise to be overly prepared, but advising someone with a $75,000 salary to save $500,000 more than they will likely need is overkill. This is why it is critical to run your own numbers, and not follow generic advice.

Paying Off Your Mortgage Before Retirement Eliminates That Expense. This is only partly true. Most people have their home insurance and real estate taxes included in their mortgage payment. If you have a $2,000 mortgage payment each month, and you pay off the balance owed, you will still need to pay for the insurance and real estate taxes. These costs vary widely, but it may be 25%-30% of your current payment. That would be $6,000 - $7,000 per year that doesn't go away. Whether you rent or own, you will always have a housing expense in retirement.

Your Budget Needs To Include Large One (Or Two) Time Expenses. Creating an itemized budget of expected expenses, and adjusting them for how they may change over time is an essential part of learning how much you may need in retirement. Food, utilities, clothing, and other every day items are easy to account for, but what is rarely mentioned is the inclusion of substantial expenditures that will (not may, but will) occur over a 25 year time frame. Factor in items such as the cost of a new car (or two) (at least new to you), a new roof for your house, painting your house, replacing a furnace or worn out major kitchen appliances (refrigerator, oven, dishwasher), a major family trip, or helping a child with a down payment for a house. These are expenses that can cost anywhere from $5,000 - $25,000 each, and they are more than likely to happen. These additions to your "regular" budget could easily require an additional $100,000 of savings . Don't forget that you will be taxed on these withdrawals, and those big chunks of savings will then no longer be generating income. These types of expenses, and the impact of withdrawing large amounts all at once, are often overlooked, or dismissed as "one time" anomalies. Either you will incur these expenses or you won't, but my bet is that you will, and it would be best to prepare for it.

Health Care Costs - The Biggest Single Wild Card In Retirement Planning. Ugh! Current guidelines suggest that a couple may need $280,000 for health care costs during their retirement. This is a median amount, and could vary considerably depending on the specifics of your general health before retirement, how you take care of yourself during retirement, genetics, the ability to avoid any health catastrophes (accidents), and pure luck or good fortune. There are no guarantees, and no way to accurately prepare for what will likely be the largest single expense in retirement, but prepare you must. When you are working, your employer is likely paying a portion of these expenses, and the remainder is being deducted from your paycheck pre-tax. You never see it. For this reason, it probably isn't included in your regular monthly household budget. While a mortgage payment (or at least part of one) is an expense that may be subtracted from a retirement budget, don't forget to add in Medicare (Parts A, B, C, and D) and all the costs that Medicare doesn't cover. When you stop working, you will be solely responsible for all of your health care costs. Medicare provides some very basic coverage, but it's not free, and even adding basic vision, dental, and prescription coverage is an optional additional cost. Most people augment Medicare with additional private health insurance plans. Make sure you are aware of what is covered, what is not covered, how much coverage you want, and the costs of all available options to be as well prepared as possible. Also, make sure that you sign up for Medicare 3 months before turning 65, even if you aren't ready to start collecting your Social Security benefit. There are penalties for not signing up on time.

Important - as you create your financial retirement plan (as you know you should), health care costs should be calculated using a separate inflation rate of 6%. This is well above the regular historical inflation rate of 2%-2.5% (and even above a 3% rate suggested for planning purposes by professional advisers), but this is what is projected by the U.S. Department of the Actuary for at least the next decade. Again, ugh!

Retirement Calculators - Great Toys For Those 12 And Under. The vast majority of articles written about retirement planning end up recommending the use of a retirement calculator (usually found on financial sites) to figure out the total amount that may be needed to save for retirement. They do this because the article is meant to discuss particular steps in the planning process, but not the mechanics involved in figuring out the entire equation. It's always easier to tell someone what to do, than to tell them how to actually do it. Fair enough, since it's an article, not an instruction course. The problem is that the calculators that they recommend have exactly the same shortfall - they're quick, and usually easy to use, but they only consider a small part of your essential information, and rely on generic assumptions that probably don't apply to you (see #1 above). Elements such as taxes, spouses retiring at different ages (any spouse information?), the ability to vary income, expenses, and savings by year, and much more, are not included. What good is a retirement calculator if it only calculates 10% of the necessary information, and uses assumptions that aren't true? Supplying 4 or 5 numbers on your part, combined with erroneous assumptions and a complete lack of pertinent information on the calculator’s part, will never yield an accurate answer to anything. That may be why they’re free, but don't be penny wise, and pound foolish. They are misleading at best, have no redeeming qualities, and should be avoided at all costs.

Think of it this way - if you are planning a trip to Paris, and will be satisfied with directions that only tell you to head East (or West!), then perhaps retirement calculators are for you. But if you'd like to know the details for available flights from your specific location, hotel choices that are to your liking, a list of activities that you might enjoy in Paris, and what all that might cost, then you will be better served by creating your own individualized retirement plan. Just as oversimplified directions won't help you to get on the right plane, an oversimplified calculator won't help you to determine your true need for retirement. There's simply too much to be considered in a reliable retirement plan that calculators aren't capable of accounting for. Shortcuts are great when they are efficient, but if they are inefficient, there is no point in taking them. Knowing the final destination for your trip isn't enough, you need to know how to get there.

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