Imagine sitting at your desk, nearing retirement, and feeling the weight of uncertainty settling in. You’ve worked hard your entire life, but now you’re faced with the daunting question: do I have enough saved for retirement?
We are frequently asked by individuals considering retirement – “how much do I need saved in investments before retirement?” It is frequently followed by the statement, “I heard somewhere you need $1 million” or some say $2 million. A coworker, a neighbor, or a friend says you need X amount to feel comfortable.
Determining how much money you need to save for your retirement is a personal number. It will be different than your coworker, friend, cousin, etc. because your financial situation is different. It is also dynamic based on your changing lifestyle and goals. The magic number loudly shouted by the financial media can be helpful to potentially provide a lukewarm direction on where you’re headed, but do you really want to leave your retirement readiness to impersonal, non-customized advice?
In this blog we will help you understand how to calculate your magic number for retirement, how to make sure you’re on track, and potential pitfalls to avoid!
The basics – what does the term “magic number” mean when referring to retirement?
The term “magic number” refers to the amount of money you need to comfortably sustain your desired lifestyle throughout retirement. Your ‘magic number’ isn’t just a random figure plucked from thin air. It’s the culmination of your unique financial circumstances, aspirations, and lifestyle preferences. In essence, it’s the amount of money you’ll need to fund your desired retirement lifestyle comfortably. Calculating this number requires a comprehensive analysis of your financial situation and future goals.
What do you want your retirement to look like?
This is the fun part. Close your eyes and envision your ideal retirement. Are you traveling the world, pursuing new hobbies, or simply enjoying quiet moments at home? The more vividly you can imagine your future, the clearer your retirement goals will become.
Do you want to stay in your current home, or do you plan to downsize? Will you take classes to learn a new language? Perhaps you expect to maintain a very similar lifestyle.
Determining if you’d like to work part-time or in any capacity is important to consider as well. With more free time and not having as much stress related to your finances, some people want to work in areas that give them more fulfillment.
Expenses and Debt
Now that you have a picture of when you want to retire and how you’ll spend your days, calculating your projected expenses comes next.
This can be a difficult exercise depending on how granular you choose to get. The further you are from your desired retirement age, the more difficult it can be to estimate what your expenses might look like in retirement because your lifestyle might change plus inflation.
If you’re close to retirement, a best practice is to go through your expenses over the last 12 months and add it up. Are there any one-off expenses that you won’t occur again, or at least for a long time? Be overly cautious about removing items because it is better to err on the size of having a larger expense number.
Next, determine if you need to add any items to this number. If you plan to travel more in retirement, how much do you intend to spend?
Then let’s identify how much debt, if any, you have. When will that debt be paid off? What is the interest rate on that debt? If you are carrying high interest rate debt, consider strategies like debt consolidation or refinancing to lower interest rates. It might make sense to accelerate your repayment timeline, so you don’t carry debt into retirement.
Income Sources and Assets
Now it’s time to focus our attention on the other side of the ledger. Next identify what income sources you will have in retirement. Do you intend to work part-time? Will you receive a pension? Are you eligible to receive Social Security? Perhaps you have a rental property.
Delaying your Social Security benefits can significantly increase your monthly payouts. For instance, if your full retirement age is 67, delaying until age 70 results in a 24% increase in benefits. To confidently determine when to file for Social Security, you need to run the numbers. Do not leave this decision to guess work. When you decide to file will be one of the most important decisions you make as it will also impact your spouse as well.
In addition to the income sources above, your investment portfolio can provide an income stream as well. Based on widely accepted research, if the portfolio is invested properly, most people will be able to withdraw between 3% to 4% of their portfolio on a yearly basis while maintaining their principal balance throughout their retirement.
Taxes!
Figuring out how you want to spend your days in retirement is fun. Analyzing how much you’re going to owe in taxes is not. However, it is crucial to have an idea what your tax burden will be.
Various sources of income are taxed in different ways. Withdrawals from traditional retirement accounts like 401(k)s and IRAs are taxed as ordinary income. For example, if you withdraw $50,000 from your IRA and your tax bracket is 25%, you’ll owe $12,500 in federal taxes.
Did you know your Social Security benefit is taxable? That’s right, the federal government taxes Social Security benefits. Up to 85% of your benefits are subject to taxes. Your state, however, may not tax your Social Security income.
If you have investments in a non-retirement account, they are taxed every year based on the dividends, income, and capital gains. Qualified dividends and capital gains are taxed at the more favorable long-term capital gains rates of 0%, 15%, and 20%. If your income exceeds certain thresholds, you’ll be taxed an additional 3.8%!
Understanding your tax liability is essential because the money you need to pay for your expenses is all after-tax. That means you may need to withdraw more from your investments than you previously thought!
There are strategies you can implement to reduce taxes in the current year or future years. One option to consider is a Roth conversion strategy, where you gradually convert traditional retirement account funds into Roth IRAs to manage tax liability in retirement.
Inflation!
Inflation was discussed with little interest over the last 30 years, but since the massive spike in summer of 2022, it has become one of the dominant topics of retirement planning.
Inflation is the general increase in the price of goods and services over time. During most years (COVID not included), it’s difficult to notice a significant difference in the price of items you buy. But the longer the time horizon, the more significant it appears.
According to the U.S. Bureau of Labor Statistics (BLS), after adjusting for inflation, $1 in 1980 was worth $0.28 at the end of 2022. That means your purchasing power decreased by 72%! To say it differently – your money would need to grow over 2.5 times just to maintain your lifestyle.
For individuals considering a 30-year retirement, it is crucial to factor the impact of inflation on your portfolio and income. If you estimate your annual expenses in retirement to be $50,000 today, accounting for an average inflation rate of 3%, those same expenses could balloon to over $121,000 in 30 years!
Health Care
Outside of taxes, health care could be the second largest expense you pay in retirement. According to Fidelity, the average 65-year-old couple retiring in 2021 can expect to spend approximately $300,000 on healthcare expenses throughout retirement, excluding long-term care.
Have you thought about the cost of long-term care? Most American’s have not prepared for the possibility they will need to go to a nursing home.
The inflation rate for senior health care services has also been soaring over the past twenty years so this is another topic that needs be thoroughly analyzed.
Investment strategy
Last be not least, to understand what your magic number for retirement is, you’ll need clarity around your investments. As we discussed in the inflation section, your money needs to grow just to maintain your lifestyle. If you are withdrawing money from your portfolio, you’ll need your portfolio to grow at the rate of inflation plus your withdrawal rate.
To create a sound investment portfolio, you must first decide what types of investments you want to own. Traditional investments include individual stocks and bonds, mutual funds, and exchange traded funds (ETF’s). From there, what percentage of your portfolio will you put into equities and bonds? The delicate relationship of risk and return becomes even more important when you are in retirement and do not have as much time to recover from a large loss.
Diversifying across asset classes like stocks, bonds, real estate, and alternative investments can help mitigate risk and maximize returns, especially in volatile market conditions.
Then comes the hard part – where do you invest? How often will review your investments? What is your strategy when the market goes through a downturn?
The question you need to ask yourself is – “Do I want to spend my retirement worrying about my investments?”
For many retirees, hiring a fiduciary financial advisor is the right path for them.
Conclusion: When is the right time to retire?
The magic number you need for retirement is unique to your personal financial circumstances. By adjusting the variables in the equation, you can arrive at vastly different numbers.
Entering retirement can be bittersweet as you leave the workforce and enter the next phase of your life. Most individuals only retire once so they do not have any experience. More importantly, you only want to do it once!
Remember, retirement planning isn’t a one-and-done process. It requires ongoing evaluation and adjustment as your circumstances change. By taking proactive steps now, you can better position yourself for a secure and fulfilling retirement.
This guide has provided the tools you’ll need and areas you should consider helping you arrive at the magic number you’ll need.
Ready to take control of your retirement future? Schedule a complimentary consultation with our experienced advisors at Dechtman Wealth Management today. With over 60 years of collective experience, they have helped hundreds of satisfied clients prepare for retirement. Let us help you navigate the complexities of retirement planning with confidence.
You can call the office at 303-741-9772 or click here to book your meeting.
