Continue Reading Below
Source: SeniorLiving.org via Flickr
One of the more common targets in retirement planning is based on you replacing 80% of your preretirement income in your retirement. At that level, the theory goes, you can more or less keep the same lifestyle in retirement as you had before retirement. On the surface, that might seem reasonable.
Dig a little below the surface, however, and the absurdity of that line of thinking quickly becomes obvious. When you get right down to it, a target based on your income may have very little relationship to the lifestyle you're looking forward to in retirement. It's a much better idea to start with a reasonable estimate of your spending and work from there than to simply presume you'll need virtually every dime coming in that you had while working.
The dangers of focusing too much on your income
The biggest problem with focusing on your income level is that it ignores key lifestyle changes that frequently happen around the time of your retirement. For instance:
- If you have a typical mortgage, that mortgage has an end date. Once the house is paid off, that's significant money you don't have to pay each month, with no other impact to your lifestyle.
- If you have children, those children grow up and will likely become independently able to support themselves. Money you had been spending on raising them gets freed up, as well.
- For most of us, Social Security and Medicare taxes stop once we stop drawing a paycheck. That's 7.65% of your salary (or 15.3% if self-employed) you no longer have to pay in taxes once retired.
- Many states offer tax breaks for retirees, which could lower your taxes. In addition, if you live in a different tax jurisdiction from where you work, your taxes can go down from no longer being connected to that job site.
- Money you spend on things like commuting, work-related networking and social events, work clothes, and other work-related activities is money you no longer need to spend.
Continue Reading Below
In addition to those "virtually automatic" cost reductions, you have other opportunities to reduce your cost of living in retirement. Think of things you can do with your time -- like cook more from scratch, make energy and water-saving upgrades to your home, and use slower, less expensive forms of transportation like the bus instead of driving -- that can lower your costs.
Even beyond that, you can often make larger lifestyle choices. Consider things like downsizing your living arrangements, moving to a lower-cost neighborhood or part of the country, or cutting out things that aren't absolute necessities like cable and/or all but one form of phone service.
Certainly, healthcare costs and the costs of hiring people to take care of tasks you used to be able to handle on your own will likely be higher, particularly in the later years of your retirement. But to the extent you can figure out ways to keep your costs down, you can likely plan for a comfortable retirement that costs substantially less than 80% of your preretirement income.
Why driving your costs down is a much more sensible idea
The lower your expected retirement costs, the less of a nest egg you'll need to cover them. A general guideline for retirees is known as the 4% rule for withdrawals. That rule says that, if you have a decently diversified portfolio, you can:
- Withdraw 4% of your starting account balance in your first year of retirement,
- Increase your withdrawals by inflation each year after that, and
- Have a very good chance of not running out of money in your retirement.
Turn the 4% rule on its head, and it indicates your portfolio needs to be 25 times the first year's expenses you need it to cover in order for it to be sufficiently funded for you to retire.
If you retire with expenses of $50,000 per year and are expecting $15,000 from Social Security, your portfolio would have to cover $35,000 per year. By the 4% rule, you would need $875,000 saved up for your retirement to be adequately funded. Cut your total expenses to $40,000 per year with the same $15,000 from Social Security, and your portfolio would only have to over $25,000 per year. That level of spending could be achieved by a smaller, easier to reach $625,000 portfolio.
Indeed, for every $100 you can cut from your monthly expenses, you can reduce the size of the portfolio you'll need at the time of your retirement by $30,000. That's a serious chunk of change that you don't have to save. That's money you can put toward your other life priorities like your children's educations and even enjoying your life's journey along the way.
It's still a big nest egg -- so get started now
Using a reasonable estimate of your retirement expenses can help you set a much more realistic target for your retirement portfolio than simply assuming you'll need 80% of your preretirement income. Still, you'll likely need several hundred thousand dollars -- or more -- saved up to comfortably retire.
The sooner you get started, the more you can rely on compounding rather than your invested cash itself to help you get there. That makes starting now, regardless of the nest egg you'll ultimately need, one of the best gifts you can give yourself.
The article Don't Believe This Common Retirement Lie originally appeared on Fool.com.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.