If you want to be sure you'll have enough money to retire comfortably, you need a good retirement savings strategy. And if you want a good retirement savings strategy, you need to know exactly what you'll be doing during your retirement. After all, how can you plan for something if you don't know what that something will entail?
If you intend to keep on living where you are now during retirement, calculating your living expenses should be fairly simple. However, many people plan to move elsewhere once they retire. Depending on whether your intended destination is an assisted living facility, a retirement community in Florida, a cruise ship, or a villa in Tuscany, it will have an enormous impact on your living expenses. A little research can usually give you a fairly accurate estimate of what living in the new place will cost. If you're decades from retirement, don't worry about getting an exact figure; as long as you're in the ballpark, you should be able to develop a good-enough plan.
Some people dream of a quiet, peaceful retirement playing with the grandkids and catching up on all the literature they never had a chance to read during their working life. Others crave a much flashier retirement lifestyle, traveling around the world or enjoying various big-city events. You'll need to factor the cost of your planned lifestyle into your list of retirement expenses, or you may find out too late that you can't afford your intended retirement lifestyle.
While your work related expenses will disappear during retirement, medical expenses are likely to more than make up for their lack. Medicare, while helpful, won't cover all these expenses for you. Indeed, Medicare does almost nothing to pay for long-term care expenses, and 70% of retirees can expect to incur such expenses at one point or another. So even if you're in good health now, you'll need to build these inevitable expenses into your retirement budget.
Whether your income comes from a paycheck or from the investments in your 401(k), the federal government wants to collect its share (and your state may have its hand out, too). And depending on just how much income you have in retirement, your tax bill can become quite burdensome. Planning for taxes as part of your retirement strategy has two major benefits: first, you can arrange your savings strategy to minimize taxes once you hit retirement, and second, making room in your budget to pay for the taxes you can't avoid will ensure that you don't have a horrible "oops" moment come April 15th.
Multiple income streams
You've probably heard more than once that investors need to diversify their investments to minimize risk. Having multiple sources of income in retirement works much like diversification; if you have several different income sources and one of them fails, you're less likely to end up in serious financial trouble than if you were depending on just one or two sources of income. Plus, if you have income sources that are both taxable and nontaxable, you'll have a much easier time managing your tax expenses during retirement. Nontaxable sources of income include distributions from your Roth accounts and interest from qualified municipal bonds. Social Security benefits may or may not be taxable depending on your total income, and distributions from traditional retirement accounts will be taxed as income.
Bringing it all together
Once you have a handle on your retirement expenses, you'll know exactly how much you'll need in income to cover those expenses. And knowing your required retirement income allows you to come up with a monthly savings requirement to have enough money to finance that income. If the number you come up with at the end of this process is just too high for you to manage, you'll need to either cut back on your projected retirement expenses or figure out some other sources of retirement income (such as a part-time job, perhaps). Another option is to push your planned retirement date into the future a bit -- delaying retirement both gives you more time to save and allows you to take advantage of Social Security retirement credits. If you're willing to work just a few years longer, you may be able to enjoy your more grandiose retirement plans after all.
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