If you do a quick Google search on retirement planning best practices, most blogs and websites tell you to anticipate needing around 80% of your current income in retirement.
This CNBC article explains the basic concept of the rule:
Many financial advisors recommend an 80 percent replacement rate. That means if you make $100,000 annually, you will need a portfolio that generates $80,000 in income each year plus annual increases to adjust for inflation.
Financial experts make the argument that retirees no longer have expenses like commuting costs, mortgage payments, Social Security and Medicare taxes, and taking paycheck money to save for retirement itself. Therefore, retirees will actually need less money to maintain their current lifestyle after they cut the cake at the office goodbye party.
Seems like a reasonable assumption, right?
Rules of Thumb are good to follow, until you realize everyone has a different fingerprint. What works for you, might not work for your neighbor.
The 80% salary replacement rule could be too low or too high depending on your current income, health, tax bracket, and anticipated retirement lifestyle.
1) It depends on your salary
Let’s say, hypothetically, you are making $1 million a year, and your monthly income outweighs your monthly costs because you’re a good saver. In other words, just because you’ve been earning a 7-digit salary doesn’t mean you need $1 million every year to maintain your current lifestyle.
After doing your spending calculations, you determine it’s possible to maintain your desired retirement lifestyle on a monthly “salary” of $25,000 a month (or $300,000 annually). That’s a FAR cry from your current salary. In the case of many wealthy retirees, the 80% salary replacement rule is too high.
Now, let’s say you are making $60,000 a year. A bigger portion of your budget is currently spent on things like housing and groceries. You may have the same health care costs as the millionaire, but they take up a bigger percentage of your retirement budget. You didn’t take much vacation time at work, so you plan on spending retirement traveling the world.
For less affluent retirees looking for adventure, the 80% salary replacement rate might be way too low.
2) It depends on your retirement lifestyle
Retirement is the ultimate weekend. In the words of my father, “Retirement is great! Every day is a Saturday.” While a permanent weekend sounds great for the mood, it can be dangerous for the wallet.
The more time you have, the more time you have to spend money. Think about it: we spend the most on weekends and vacations: traveling, taking day-trips, eating at restaurants, going to concerts and shows, going to the movies, walking around the mall, etc.
Retirement is a permanent vacation. Unless you’re planning to live that Boo Radley lifestyle and never leave the house, you will probably need significantly more than the 80% salary replacement.
3) It depends on your health
Will you live to be 100 years old with a clean bill of health? Or maybe you’re already spending thousands of dollars on out-of-pocket medical expenses for a chronic illness. On average, medical costs get more expensive in retirement, and it’s important to be prepared.
According to Investment News:
Health care costs in retirement can exceed those covered by heavily subsidized employer health insurance plans that pay 75% of premiums on average. And health care inflation is running at about 6% per year, twice the historical rate of inflation. High-income retirees, defined as those with annual income, including tax-free interest, in excess of $85,000 for singles and $170,000 for married couples, are also subject to monthly Medicare premium surcharges.
Personally, I’d rather have the unplanned medical expense money and not need it, than need it and not have it.
4) It depends on how much you will be taxed in retirement
It’s called a pre-tax retirement contribution for a reason. Oh yeah, you pay taxes in retirement- and not all retirement income is taxed equally. States have different tax policies too, which means some tax retirement income while others don’t.
Kiplinger put together a great summary of how different types of retirement income are taxed, and they updated it for 2017. You can read it here and I highly recommend you do, right after I wrap up this blog post in the next couple sentences.
Using the “80% Salary Replacement Rule” is a good thought experiment to motivate yourself to save money. However, the best way to determine your retirement “number” is to sit down with a Certified Financial Planner® professional who can assess your current cash flow, and discuss your retirement lifestyle goals.
A good financial planner can help you figure out:
- How much money will I need to comfortably retire?
- Can I afford to retire right now?
- Are we spending too much too early in our retirement?
- Can we afford to lend money to our children?
- Should we keep or sell our home? Is it time to downsize?
- When should I start taking Social Security?
There are no cookie cutter answers to these questions. That being said, there is one “Rule of Thumb” I will always believe: The only thing worse than getting old, is getting old and running out of money.