3 Steps To Retirement Income Planning

Many people ask the same question: “how much money do I need to retire?” To answer this question you must answer two others first: The 1st question is; “how do I want to live?” because that will define your monthly income needs. The 2nd question is; “how much money do I need each month to live that way?” When you have answered these two questions everything else is easy. So lets focus on these two questions.

The smartest thing to do is compare your plan for the future with what you know best, your life and budget today. For planning purposes you can ignore inflation if your income streams are properly balanced to meet or exceed inflation. Yes, your costs will be higher in the future but so will your income so don’t worry about that. Do worry about taxes or you will be in peril of paying taxes on your Social Security pension. I will explain taxes in a later post. If you don’t follow this advice you will make it extraordinarily difficult to figure out a plan.

In order to handle “what if” scenarios it is best to setup a spreadsheet so that you can try different retirement ages or different debt scenarios. Doing this makes it relatively simple to apply tax rules also. It’s easier than you think and provides great information about the tax ramifications of decisions. Let the computer do the number crunching.

So the concept is to figure out the difference between your budget today and your budget when you retire, all in today’s dollars.

  1. Use your current budget to create your “future spending” budget. If you don’t have it on a spreadsheet then do that first. It will make things a lot easier later. Look at your current budget, line by line, and remove or change today’s budget numbers. E.g. If you intend to move will the real estate taxes be the same or less? Will you have a mortgage payment? How many cars will you be paying for, etc? Correct all those numbers for your future plan. Later on, when things look ugly, you can come back to these decisions and try different ones, the spreadsheet will help tremendously.

As an example, I will move house, travel somewhat, spend winters in the Caribbean, buy quality health insurance coverage and have the financial freedom for any hobby or recreation I may come up with later. It doesn’t take a rocket scientist to check rental costs in the Caribbean, medical costs, real estate costs etc, but you must answer this type of question and put a dollar figure on it. Add these numbers into your spending plan. If you mean to carry on as you do today then today’s spending budget will work. The only rule is to be honest about costs. Now, on paper at least, you have the life you wish for, all you have to do is pay for it. Go to step 2.

2. To complete this picture all you need is the monthly income picture. Since we can’t second-guess what the government will do, all we can do is use current information and build contingency into our plan. Use the social security pension projections, your private pension projection and apply the government rules on social security taxation in government publication 915, which you can get here. Don’t forget to add contingency into the overall budget and see how it looks. I will almost guarantee it looks ugly. This is the moment when you know you will be poor folks, that is, unless you planned for retirement. Go to step 3.

3. The gap between what you want and what you have must come from investments or other income streams. Lets say the gap is $1000 a month. Then your plan is short $12000 per year. According to my guiding principles this represents 4% of your savings, which means you need savings equal to $300k, and it must grow at a rate that meets or exceeds inflation plus the 4% drawdown. This is how you take care of inflation and why you do not need to figure it in to your plan today. Make sense?

In case you didn’t catch this, a very useful rule of thumb is that for every 300k of nest egg you can draw $1000 per month or some fraction of that. E.g. $150k gets $500/month, $450k gets $1500/month. See, you can do it in your head. Who needs a consultant?

So now you have a budget, a savings plan and a life. Now you are in control until the government changes something, so stay in touch with the news and adapt your plan. Keep your spreadsheet up to date.

My next two posts will be:

  1. The basic tax rules and how to protect your pension from Uncle Sam.
  2. What to do with that 300k, or whatever your nest egg happens to be.

So check back often.