To get a rough budget for retirement, you'll need to estimate your overall expenses, your sources of income, and how long you need your income to last. The method outlined here is a first step, an approximation. It won't answer every question, down to the last dollar. But it's a very good start.
Outline
Briefly, the method relies on five "round numbers" that are close enough for a rough budget.
- Find Life+6, your life expectancy plus an extra cushion of six years.
- Use tax returns and account statements from last year, plus the inflation rate for the past 12 months, to estimate your annual expenses this year. This number is what you actually spent last year, including tax payments, but excluding income you saved, all adjusted for current inflation.
- Find your stable income from Social Security, pensions, income annuities, and reliable work, also adjusted for current inflation. Life+6 plays a part in calculating this number.
- If your stable income won't cover your annual expenses, find your spending balance. This is the amount available to extract from your spending account. A spending account is a temporary reserve where you manage one or two years of living expenses.
- If your annual expenses are still not met, calculate the safe payout you can take from your retirement accounts and taxable savings. With Life+6, there's a simple, reasonable way to do this calculation. (Our safe payout calculator does it for you, and offers other options, as well.)
Life Expectancy
Your life expectancy will guide how quickly or slowly you spend down your retirement savings. To estimate your life expectancy:
- Visit the Social Security website and use their life expectancy calculator for your gender and current age.
- Add six to the number of years provided by the calculator.
- Write down this sum as your Life+6 number. You'll need it later.
Annual Expenses
There are two ways to estimate your expenses. In the bottoms-up method, you itemize your actual expenses and add them up. Doing so requires a lot of discipline, and it's easy to overlook some items. You may want a bottoms-up analysis later, but first try a top-down estimate that tells how much you actually spent on anything, whether taxes, housing, food, or whatever. It's income that you received last year but did not save, adjusted for possible inflation this year. To calculate it:
First, assemble last year's tax returns, both state and federal, and end-of-year statements from your banking, investing, and retirement accounts.
Second, determine your gross income, before any amount was paid or withheld for taxes, retirement accounts, pensions, health insurance or other items. Count the following as income:
Third, find your new savings. This number is the amount you added to your savings, investment, and retirement accounts. Include the following:
Fourth, estimate your annual expenses as gross income minus new savings. If necessary, adjust your annual expenses for large expenses that you know will be different this year compared to last. For example, if you paid off a mortgage, decrease your annual expenses by the total mortgage payments you made last year. To be large enough, the adjustment should be 5% or more of your estimated expenses. Otherwise, it's not worth the bother for a rough budget.
Finally, adjust for current inflation. At this website for the Bureau of Labor Statistics, scroll to the very bottom of the table, where you will find the so-called "core" inflation rate. It's based on the Consumer Price Index, with energy and food prices excluded because of their high volatility. As of October 2015, core inflation was 1.7% for "Half1" of 2015 compared to the same period in 2014. Add the relevant percentage to your annual expenses from last year. For example, if your annual expenses were $45,000 and the inflation rate were 2.1%, you would adjust your annual expenses to $45,000 * (100 + 2.1) / 100 = $45,945. Note that in the very rare circumstance that core inflation turned negative (because of deflation), you would adjust your annual expenses down, not up.
Historically, last year's core inflation has been a decent predictor of inflation this year. It may not be spot on, but it's unlikely to be way off. For most purposes, it works just fine. (A slightly better value, used in our safe payout calculator, comes from a survey of professional forecasters.)
First, assemble last year's tax returns, both state and federal, and end-of-year statements from your banking, investing, and retirement accounts.
Second, determine your gross income, before any amount was paid or withheld for taxes, retirement accounts, pensions, health insurance or other items. Count the following as income:
- Money you earned from working,
- Pre-tax payments you received from Social Security, annuities, or a pension.
- Withdrawals you took from any IRA, 401(k), 403(b), 457 or other retirement account, including any spending from Roth accounts.
- Income you generated by selling investments or spending dividends or interest from a taxable account, excluding any money that was immediately reinvested.
Third, find your new savings. This number is the amount you added to your savings, investment, and retirement accounts. Include the following:
- Deposits you made into any IRA, 401(k), 403(b), 457 or other retirement account, excluding any transfers or roll-overs from one retirement account to another.
- New amounts invested into an annuity or a whole life or universal life insurance policy, except when the investment was transferred from an existing retirement account or savings balance.
- Deposits you made into taxable accounts, brokerage accounts, mutual funds, banks savings, or CDs.
Fourth, estimate your annual expenses as gross income minus new savings. If necessary, adjust your annual expenses for large expenses that you know will be different this year compared to last. For example, if you paid off a mortgage, decrease your annual expenses by the total mortgage payments you made last year. To be large enough, the adjustment should be 5% or more of your estimated expenses. Otherwise, it's not worth the bother for a rough budget.
Finally, adjust for current inflation. At this website for the Bureau of Labor Statistics, scroll to the very bottom of the table, where you will find the so-called "core" inflation rate. It's based on the Consumer Price Index, with energy and food prices excluded because of their high volatility. As of October 2015, core inflation was 1.7% for "Half1" of 2015 compared to the same period in 2014. Add the relevant percentage to your annual expenses from last year. For example, if your annual expenses were $45,000 and the inflation rate were 2.1%, you would adjust your annual expenses to $45,000 * (100 + 2.1) / 100 = $45,945. Note that in the very rare circumstance that core inflation turned negative (because of deflation), you would adjust your annual expenses down, not up.
Historically, last year's core inflation has been a decent predictor of inflation this year. It may not be spot on, but it's unlikely to be way off. For most purposes, it works just fine. (A slightly better value, used in our safe payout calculator, comes from a survey of professional forecasters.)
Stable Income
In a nutshell, stable income is what you receive from sources you can depend on, with little or no variation, adjusted to keep up with inflation. To estimate the value, follow these steps:
First, multiply your monthly Social Security benefit for the year ahead by 12, and use the result as the starting value of your stable income. (The value will be zero if you don't qualify for Social Security benefits.)
Second, if you have a pension, does it have a cost-of-living adjustment (COLA)?
Third, if you have any annuities, the same question applies. Do they have a COLA? The options are similar to those for a pension, although slightly more complicated.
Fourth, are you working while retired, at a job with predictable income? If so, increase your stable income by the pre-tax pay you expect to receive from the job, this year.
First, multiply your monthly Social Security benefit for the year ahead by 12, and use the result as the starting value of your stable income. (The value will be zero if you don't qualify for Social Security benefits.)
Second, if you have a pension, does it have a cost-of-living adjustment (COLA)?
- If yes, multiply the monthly pension payment for the year ahead by 12, and add it to your stable income. Then skip ahead to the next step, annuities.
- Without a COLA, a pension must be adjusted because its buying power in the future will diminish. To compensate, you must either save some of it for future spending, or plan to spend more in the future from other sources, such as your IRA. Either way, we can estimate the effect by approximating what, in the jargon of finance, is called your pension's present value.
- Recall your Life+6 value? For each year of Life+6, reduce your pension's annual value by 1%. This mark-down approximates the present value of a pension with fixed payments that are discounted by inflation at 2% to 3% per year, for an period that may last five to 30 years.
- For example, if your monthly payment is $750 and your Life+6 is 18, the calculation goes like this: Adjusted Annual Pension = 12 * 750 * (100 - 18) / 100 = $7380.
- After calculating your adjusted annual pension, add it to your stable income.
Third, if you have any annuities, the same question applies. Do they have a COLA? The options are similar to those for a pension, although slightly more complicated.
- For an annuity with a guaranteed annual increase of 2% or more, or an automatic inflation-adjustment tied to the Consumer Price Index, increment your stable income by the annuity's total payment for the year ahead, and go to the next step, working while retired. (We'll feign indifference to what may happen if your guaranteed annual increase is more than 4%, which might, in the long run, outpace inflation and sweetly boost your buying power.)
- If an annuity pays a fixed amount, with no guaranteed increase of any kind, then estimate a mark-down equivalent to the one shown above for a pension that has no COLA. Add the adjusted annual annuity to your stable income, and skip ahead to working while retired.
- If it's a variable annuity whose payments can go either up or down, ignore what it paid last year and use instead what it will pay this year. Get the annual total (12 times the monthly payment), and add it to your stable income.
- Finally, suppose your annuity pays an annual increase of 1% or has a rider that guarantees no decrease and proffers a potential increase, depending on the stock, bond, or options markets. Then strike a compromise. Modify the mark-down shown above for a pension, using the monthly annuity payment and half your Life+6 value. In the example above, you would increase your stable income by 12* 750 * (100 - 9) / 100 = $8190.
Fourth, are you working while retired, at a job with predictable income? If so, increase your stable income by the pre-tax pay you expect to receive from the job, this year.
Spending Balance
Your spending balance is the current amount in an account that holds temporary reserves to support one or two years of living expenses. To establish a spending account, if you don't already have one, you must first calculate the difference between your annual expenses and your stable income.
Continuing the earlier example, let's suppose that your annual expenses, adjusted for inflation, are $45,945, but your stable income is less, $36,575. Then you have a gap of $9370 per year, or $781 per month. To manage your budget, we recommend that your checking account should have three months' coverage of the gap, or 3 * $781 = $2343, and a separate spending account should have one to two years coverage of the gap, or $9370 to $18,740.
A spending account could be invested in T-Bills at www.treasurydirect.gov, or in an FDIC insured savings account that earns more than T-Bills, or in a mutual fund of short-term government bonds. You may find it advantageous to create the spending account within a retirement account, such as an IRA. In that case, a mutual fund of short-term government bonds might be the best option.
During the course of the year, you would transfer funds from your spending account (where you are safely earning interest) to your checking account (to pay your bills). Your checking account would also get deposits of your stable income from Social Security and any pension or annuity you may have.
At the end of the year, your checking account should have a balance to cover some of your needs for the coming year, because:
To true-up your accounts for the following year, you would re-estimate your Life+6 number, your annual expenses for the year ahead, and your stable income. Using the updated numbers, plus the balance in your checking account, you would replenish your spending account to the extent necessary to cover the gap between your newly estimated expenses and income. You want three months of gap-coverage in your checking account and one or two years of gap-coverage in your spending account.
The replenishment would come by taking safe payouts, either from a taxable investment account or from your retirement accounts.
Continuing the earlier example, let's suppose that your annual expenses, adjusted for inflation, are $45,945, but your stable income is less, $36,575. Then you have a gap of $9370 per year, or $781 per month. To manage your budget, we recommend that your checking account should have three months' coverage of the gap, or 3 * $781 = $2343, and a separate spending account should have one to two years coverage of the gap, or $9370 to $18,740.
A spending account could be invested in T-Bills at www.treasurydirect.gov, or in an FDIC insured savings account that earns more than T-Bills, or in a mutual fund of short-term government bonds. You may find it advantageous to create the spending account within a retirement account, such as an IRA. In that case, a mutual fund of short-term government bonds might be the best option.
During the course of the year, you would transfer funds from your spending account (where you are safely earning interest) to your checking account (to pay your bills). Your checking account would also get deposits of your stable income from Social Security and any pension or annuity you may have.
At the end of the year, your checking account should have a balance to cover some of your needs for the coming year, because:
- You started the year with three months of gap-coverage, and kept about that much on hand throughout the year, provided your budget was accurate.
- Additionally, if your pension or annuity has no COLA, the mark-down you applied when estimating your stable income means that the actual deposits probably exceeded what you spent.
To true-up your accounts for the following year, you would re-estimate your Life+6 number, your annual expenses for the year ahead, and your stable income. Using the updated numbers, plus the balance in your checking account, you would replenish your spending account to the extent necessary to cover the gap between your newly estimated expenses and income. You want three months of gap-coverage in your checking account and one or two years of gap-coverage in your spending account.
The replenishment would come by taking safe payouts, either from a taxable investment account or from your retirement accounts.
Safe Payout
A safe payout is the amount you can spend this year from your retirement and taxable savings accounts, with reasonable assurance that your funds will last your lifetime. One method of computing your safe payout has two simple steps:
The Life+6 method aims to spend as much as you safely can, although it saves a cushion for living longer than expected. The cushion may be left as an inheritance. Depending on your personal goals, you may prefer a more cautious payout, if you can afford it. Our safe payout calculator does the Life+6 calculation plus two others. One, called "collared inflation," estimates the minimum payout you can take to keep your spending in line with inflation, thereby maintaining a smooth standard of living. The other, a FlexBequest method, estimates the payout you can take when aiming to preserve a substantial balance as a bequest to your heirs or charity.
It's important to note that a safe payout is different from a Required Minimum Distribution (RMD) mandated by the IRS after you reach the age of 70 years and six months. If you have RMD withdrawals, we recommend managing them as follows:
- Sum up the current balances of all your retirement and taxable savings accounts, except for your spending account and your checking account. (Some variable annuities may allow optional payouts, perhaps until you reach a certain age. If so, you can add the annuity balance here.)
- Divide that sum by your Life+6 number.
The Life+6 method aims to spend as much as you safely can, although it saves a cushion for living longer than expected. The cushion may be left as an inheritance. Depending on your personal goals, you may prefer a more cautious payout, if you can afford it. Our safe payout calculator does the Life+6 calculation plus two others. One, called "collared inflation," estimates the minimum payout you can take to keep your spending in line with inflation, thereby maintaining a smooth standard of living. The other, a FlexBequest method, estimates the payout you can take when aiming to preserve a substantial balance as a bequest to your heirs or charity.
It's important to note that a safe payout is different from a Required Minimum Distribution (RMD) mandated by the IRS after you reach the age of 70 years and six months. If you have RMD withdrawals, we recommend managing them as follows:
- First, create or replenish your spending account in a taxable fund, outside of your retirement accounts. In effect, you transfer the spending balance from a retirement account into a taxable one, because of the RMD.
- Second, if your spending account is fully funded, and you need additional funds to meet your annual expenses, use the RMD to fill the gap.
- Finally, after replenishing your spending account and meeting your annual expenses, if some of the RMD remains, invest it in a taxable investment account. Our article on basic portfolios or the Best-Invest calculator could help you decide how to set up the account.
Summing Up
You can manage your retirement budget with five round numbers, computed once a year. Start by refreshing your Life+6 number. Then use last year's spending and inflation rate to estimate your annual expenses for the year ahead. Next find the stable income you can expect from reliable, inflation-adjusted sources such as Social Security, a pension, or some annuities. If there's a gap between your projected income and expenses, cover it with your spending balance from a separate account whose purpose is to reserve a year or two of living expenses. Replenish that account, and if necessary, fill any remaining gap with a safe payout from your retirement accounts and taxable long-term investments.
With these numbers in hand, you may need to re-evaluate your personal goals. Can they be met with the budget you have developed? Do you have new insights that may cause you to re-prioritize your goals?
Last but far from least, if you have done your round numbers and want to manage your budget in more detail, we highly recommendthat you try ESPlanner Basic, a free online application that will generate a multi-year table showing your income, expenses, account balances, taxes, and more, along with a projection of the amount you can afford to spend to maintain a smooth standard of living throughout your lifetime. To get started, watch the videos at the website for ESPlanner Basic.
With these numbers in hand, you may need to re-evaluate your personal goals. Can they be met with the budget you have developed? Do you have new insights that may cause you to re-prioritize your goals?
Last but far from least, if you have done your round numbers and want to manage your budget in more detail, we highly recommendthat you try ESPlanner Basic, a free online application that will generate a multi-year table showing your income, expenses, account balances, taxes, and more, along with a projection of the amount you can afford to spend to maintain a smooth standard of living throughout your lifetime. To get started, watch the videos at the website for ESPlanner Basic.
Disclaimer: Historical data cannot guarantee future results. Although a mixture of bonds, stocks, and other investments may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, firm, or type of insurance. You are responsible for your own investment decisions. Please read our full disclosures and Fiduciary Oath.