One of the most common retirement planning errors is setting income goals artificially high - causing many retirement plans to look much bleaker than reality. If you're working hard on your finances, the odds are that when you retire, a large portion of your expenses will go away in your golden years. The key to setting an 'accurate' retirement income goal is to take the time to consider what your life will look like down the road. To help you through this process, we've broken it down into three simple steps.
Step 1: Start with Your Gross Income
The starting point for this calculation is your gross annual household income which is defined as your total income before taxes. While you can look at a number of line items on IRS forms, the best way to think of this number is, "What are you living off of today, before taxes?" Once you have this number, record it on paper, in a spreadsheet, or wherever it is convenient.
Step 2: Subtract Taxes, Savings, and Debt
The three items above will vary as a percentage of your total income, but they will typically combine for anywhere from 20% to 50% of your total income. The reason we subtract these three items is we're trying to find your after tax income required during retirement, so today's taxes must be taken out of the calculation. In addition, when you retire, you'll no longer be saving and by that time, you should be completely debt free. Because of these facts, subtract your income taxes, savings, and debt servicing payments (principal and interest, not escrows for taxes or insurance).
Step 3: Adjust for Lifestyle Changes
The final major step is to adjust for any lifestyle changes. For example, when you're just starting your career, you may expect an upgrade in lifestyle whereas when you're in your peak earning years, a lifestyle decrease may be appropriate. Either way, adjusting for lifestyle changes involves considering very carefully what your life will look like and what that will cost when you retire. Once you've adjusted for these changes, you'll have a fairly 'accurate' retirement income goal.
Application: Joe, Age 30
As an example, let's look at Joe who earns $40,000 annually, pays $4,000 in income taxes, saves $6,000, and shells out $5,000 in debt payments each year. He is still far from his peak earnings years and has yet to start a family. He expects his lifestyle to increase to the tune of $8,000 annually. To calculate his retirement income goal, we do the following:
- $ 40,000 - Gross Household Income
- - 4,000 - Income Taxes
- - 6,000 - Savings
- - 5,000 - Debt Payments
- + 8,000 - Lifestyle Increase
- $ 33,000 - Retirement Income Goal
Wrapping Up
Throughout this post, we've used quotation marks around the word 'accurate' because when it comes to retirement planning, there is no such thing as accurate. If you think about retirement planning, it is an attempt to prepare for your future that is constantly changing. Tax rates, investment returns, and your spending will never be constant.
As a result, the best you can do is re-evaluate your retirement income goal each year to make sure that your target is a reasonable expectation of the future. From there, a great deal of mathematics (a subject for another day) can be applied to account for changes in tax rates, investment returns, and spending patterns, but all of this will be centered on your income goal. If you can be realistic in your goals, and not simply plug in your income today, you'll be well ahead of the game.
I agree retirement planning is very important. I have read some great articles, and this is one of the simplest to understand. Now I know what these retirement calculators I see online are trying to do.
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