Every retirement plan is unique and asks the age old question: How much do I need to retire? It takes a lot of finesse to devise each individual’s “magic” retirement age and dollar amount. The industry’s rule of thumb is to draw down 4% of one’s assets in a 60/40 portfolio, which often leads to the best probability of sustaining a 30yr retirement. Personally, I hate using that “rule;” the answer is far from that simple. When trying to ascertain your personalized retirement age, here are some items to consider.
Work Backwards You can’t determine what you need if you don’t know how much you should anticipate retirement to cost. Start by figuring out the type of retirement you want. If you are like most, you want to maintain your current lifestyle. With that assumption, do you really have a good sense of your expenses? Most people’s estimates are off by 10–20%. If you’re planning a long retirement and are under by 10%-20%, it will make a significant difference. If you don’t keep good records, I suggest looking at your current after-tax paycheck. Then, add back health insurance costs and subtract any additional after-tax savings. This should reveal your estimated monthly costs. Additionally, you must account for large expenses and make a loose assumption on life expectancy. (I recommend spending 5 minutes on livingto100.com to get a rough sense of your life expectancy.) With the constant increase in modern medicine, I always recommend adding a few extra years to the end of your assumption. Below is a great visual:
Inflation Once you understand your expenses, you’ll need to get a sense of the inflation rate at retirement. I tend to use 3% for inflation as it’s close to historical rates. Today, however, we are in a low inflation environment of approx 2%, which happens to be the Federal Reserve target. Another quick tip: grow your health care expenses by a higher rate of return, say 5%. Legacy What is the amount of money or legacy you want to leave behind? I’ve heard everything from “I want my last check to bounce” to “I’d like to leave each kid $1,000,000.” Think through this carefully. If you don’t, it will be determined for you.
Retirement Income How will you fund retirement? It’s critical to get a sense of what will be funded from fixed income. I assume you and your spouse will receive Social Security. That said, estimate minimal to no growth on these figures. Therefore, what other type of incomes will you have? (Pensions? Annuities? Part time work?) Whatever it might be, it’s important to get a clear sense of how much these fixed incomes will be and when you’ll receive those dollars.
Taxes Understanding how your current assets are held helps you understand the tax implications. Broken down to four categories (IRA’s, Roth IRA’s, cash, and Non-Retirement investment accounts), presume the tax treatment is as follows:
- Traditional IRA/401(k)– taxed as if it is all ordinary income.
- Roth IRA – no taxes owed when taking withdrawals.
- Cash – no taxes owed when taking withdrawals.
- Non-Retirement Investment Accounts – growth taxed at long term capital gain rate (15% if married and under $250,000 of AGI).
Stay away from guessing the future tax rates and just use the current ones. Here is a link from the Diversified website to understand 2017 rates: Tax Rates 2017.
Investment Mix & Returns The final piece is your risk tolerance and investment mix. Think of these things as return over your inflation rate. This is very important. Cash earns 0% and inflation of 3% actually looses purchasing power value. I like to reverse solve this as well. Understand the amount you want in “safer” assets, along with the “riskier” assets. It’s important to find that specific comfort zone for you. Emotions are the number one detractor from achieving your desired investment returns, so stick to the plan. I’d assign a 6-8% growth rate to stocks, 3-5% growth rate to bonds, and 0% growth rate to cash.
My Magic Number! Hopefully, you now have a sense for: what it costs to be you; how long you (approx) expect to live; how your costs will grow; what legacy you want to leave behind; what income to be expected in your retirement; and what taxes are owed on redeeming your assets. With this information, you can assign amounts to everything. It will help you solve for what your “magic” number truly will be. You only get one shot at retirement; make it a great one!