Here's an often-misunderstood retirement concept: Being ready to retire isn't necessarily about how much money you have in savings. The much more important factor is how much sustainable income you'll have.
For example, if you have a pension, Social Security, and an annuity, all of which are inflation-adjusted each year, and this combination is more than enough money to live on, it doesn't matter too much if you have a million-dollar 401(k). On the other hand, if your only guaranteed source of income is Social Security, having a stockpile of savings that you can use to create income becomes much more important.
With that in mind, here's a quick overview of the basic retirement income rule of thumb and how to modify it to determine how much income you will need in retirement.
The "80% rule" and where it comes from
Financial planners (myself included) often tell clients that they should anticipate needing about 80% of their pre-retirement income after they retire in order to maintain the same standard of living they're used to. The number varies slightly, but is generally between 70% and 80%, depending on who you ask.
You may be wondering: "Where does that 80% figure come from? Wouldn't I need 100% of my pre-retirement income to sustain the same lifestyle?"
Well, not really. The idea behind the 80% rule is that there are some expenses you naturally won't have after retirement. For example, if you commute to work now, you'll probably have lower expenses for things like gasoline and auto maintenance or won't have to pay as much for public transit if you go that route.
And don't forget about the expense of retirement savings itself. The average worker contributes just over 6% of their salary to retirement savings, which will be unnecessary after retirement for obvious reasons.
The point is that after subtracting expenses you will no longer need to worry about, the 80% figure is generally accurate for the average American.
Things that could add to your income need
While the 80% rule is accurate for the average American, your individual situation may not exactly be "average." There are several factors that could increase or decrease your retirement income needs.
Here are a few factors that could push your income need significantly higher than 80% of your pre-retirement salary:
- If you plan to travel extensively in retirement, it could require a much larger budget. For instance, although I'm pretty far from retiring, my wife and I have ambitious plans to take an around-the-world cruise in our first year of retirement. To put it mildly, that isn't going to happen if we only plan to spend 80% of our current income.
- On a similar note, if you plan to pursue a potentially expensive hobby, it could also require significantly more income.
- If you plan to retire early (before 65) and won't be able to maintain health insurance through your employer, you'll need to pay for it out-of-pocket. Be sure to account for this expense as well.
Things that could reduce your income need
On the other hand, there are some factors that could reduce the amount of income you'll need to live on in retirement.
For example, if you are used to saving significantly more money than the average American, you're already used to living on a smaller percentage of your salary.
Or, maybe you plan to eliminate some debt before you retire. One common strategy pre-retirees use is to try and pay off the mortgage prior to retiring. So, if you're used to making a mortgage payment each month and will no longer need to do so after retiring, it could dramatically reduce your income need. The same goes for your car payment, student loans, or credit card debt.
Finally, maybe you just plan to live a much simpler or scaled-down lifestyle than you do now. Downsizing to a smaller home could translate to much lower maintenance and utility costs. Maybe you and your spouse could manage with one car instead of two after retirement. Things like these could help lower your required income significantly.
So, how much will you need?
The bottom line is that the standard rule of "80% of your pre-retirement income" is a good rule of thumb if, and only if, you don't plan to make any significant budget-altering changes after retirement like those I've mentioned here.
For most people, the 80% rule is a good starting point. Figure out what 80% of your current income is, then adjust this figure up or down according to your plans.
As a simplified example, let's say that between you and your spouse, your current income is $100,000 -- 80% of that is $80,000. However, we'll say that you plan to spend about $15,000 more on travel annually than you do now but you also plan to have your mortgage completely paid off, which will reduce your expenditures by $12,000. This translates to a $3,000 net increase, so you can plan to need roughly $83,000 per year in retirement.
Knowing your approximate retirement income requirement is perhaps the single most valuable tool when it comes to retirement planning, as it is the first step in determining your retirement savings needs.
The $16,728 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.