How much invested money do you need to cover your expenses in retirement?
The general rule of thumb is that you need at least 25 times your annual expenses to be able to safely withdraw, cover your expenses, and not run out of money before you die. This is known as the 4% rule of thumb.
Others have written about the merits and complexities of this rule (and this is just the starting point for determining ‘how much is enough’).
- Mister Money Mustache’s take
- Michael Kitces’ thoughts
- Big ERN (Karsten)
- Fritz Gilbert – the Retirement Manifesto – he has links to many related sites in this post.
In this post I want to cover a specific aspect of this calculation that changes from pre-retirement to post-retirement.
If you are earning a paycheck before you retire and you take the time to document and analyze your expenses you may have a list that looks something like this:
- Housing costs (rent or mortgage, property taxes, utilities, upkeep, insurance)
- Food costs (eating in and dining out)
- Non-food supplies (toilet paper, tissues, laundry detergent, etc.)
- In-home entertainment (internet, TV/film subscriptions)
- Phone
- Transportation costs (car upkeep, gasoline, insurance, registration, commuting fees)
- Outside entertainment not covered already (vacations, event costs, hobby costs)
- Other Insurance (Umbrella, other policies not mentioned)
- Medical costs for doctor visits, medicines, dental care and vision care
What is not covered typically are health insurance premium costs and taxes. This is because these costs were previously taken out of your paycheck and you were looking at costs using your checking account and credit card statements. Honk your horn if you agree.
You were looking at:
SBITHC: Spending Before Income Taxes and Health Care
(When I look at some investment opportunities EBITDA comes up: Earnings Before Income Taxes and Depreciation. Somehow I connected these two concepts. Strange, huh?)
If the money you spend in retirement comes from after tax savings, from a Roth IRA or an HSA, you do not have to pay income taxes on these funds as you have already paid them.
On the other hand, if like many of us baby boomers, a substantial portion of your spending will likely come from your pre-tax investments (IRA, 401K, 403B, etc) or from interest, dividends and capital gains on investments held outside a tax-deferred account, you will probably be paying some income taxes.
In the past, your taxes were withheld from your paycheck and you just reconciled with the IRS every spring. Now, you will have to learn how to estimate these taxes and pay them quarterly, or pay someone to do this (and add that cost to your expenses).
Simple Example for a married couple who are at least 59.5 years old (or otherwise able to withdraw from their retirement accounts).
Suppose life (all the expenses mentioned at the top of this article – your SBITHC) costs you $50,000 a year. Multiply this by 25 and your minimum needed to retire is $1.25 million. (4% of $1.25 million is $50,000 – that’s how this rule of thumb works).
Now suppose all of that money is in a tax deferred vehicle (IRA, 401K, etc) and you must pay taxes on it.
As of this writing, a married couple would have to pay about $2600 in federal taxes on $50,000 of income. State income taxes would of course vary by state.
If federal and state income taxes were not in your budget, your real costs are now closer to $53,000 per year and the amount needed is now at least $1,325,000.
As the TV announcer says, ‘but wait, there’s more.’
You are probably on an employer subsidized health care plan – the subsidy is often 80-95% of the premium and the benefits may be better than what you can get from the ACA market place.
So now we have to add in the cost of the premiums and the extra out of pocket costs, remembering this is not just for medical, but for dental and vision as well.
So again, for simplicity we will add $24,000/year for these costs. This number will be high for some, but may be low for others.
It appears now that life costs about $74,000 per year before taxes. To have $74,000 left after taxes, a married couple might need something closer to $90,000 per year to have enough left over after federal and state taxes to be able to afford the extra medical costs and still have about $50,000 left over for their ‘normal’ SBITHC spending.
$90,000 per year in taxable income requires a minimum of $2,250,000 invested to cover this amount.
This was a simplified example. Different types of income are taxed differently, or not at all. Consider:
If $1 million of your investments were in a ROTH vehicle, and you are already 59.5 years old you could choose to use up to $40,000 towards your annual expenses without paying taxes on them.
If you managed to save $1 million outside of retirement funds altogether, ie, in your brokerage and savings accounts, you could choose to fund another $40,000 per year from savings. Alternatively, assume $700,000 of these funds are in fully qualified dividend investments paying on average 4%, generating $28,000 per year in dividend income.
If you can use some combination of these examples, your spending might still be $74,000 per year, but the taxes needed to support that spending might be much lower, maybe as low as 0. (I am not a tax professional, do your own due diligence – anyway tax law changes continually so this paragraph will lose some accuracy over time).
If you have started collecting social security, note that it may be considered partially or fully taxable income, depending on how much other income you earn.
If you are hoping that Medicare will reduce your health expenses that may be true, but it will not reduce them to $0, or anywhere near it. There are many choices to make, so each couple will have a different experience (location matters as well), but do not be surprised if you are still spending as much as $12,000 a year or more once your are both enrolled.
Roger Whitney, the Retirement Answer Man, does a great job exploring this (and scaring me) in his series of podcasts of September, 2020.
In summary, remember to add income taxes and additional health care costs (premiums and larger deductibles and co-pays) into your calculations when determining how much you will need to have saved before you retire.