Retirement planning can be full of complicated calculations and projections. Whether you’re estimating a reasonable withdrawal rate from your investment portfolio or minimizing your tax liability, you have many decisions to make as you plan your golden years. But figuring out how much money you’ll need each year in retirement doesn’t have to be challenging thanks to a simple rule from T. Rowe Price. The financial services firm found that a 75% income replacement rate is a good starting point for most retirees when calculating this all-important figure. Here’s why.
A financial advisor can help you plan for retirement and build income streams to meet your needs.
75% Rule: Your Income Replacement Target
Your income replacement rate is the percentage of pre-retirement income that you’ll need to fund your lifestyle once you stop working full-time. Retirees typically rely on a combination of investment income, Social Security and other sources to replace their pre-retirement income.
Some experts recommend replacing anywhere from 55% to 80% of pre-retirement income, but T. Rowe Price lands on 75% as a suitable target.
Why 75%? The financial services firm found that a combination of three factors reduces a retiree’s income needs by 25%:
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Lower tax liability: T. Rowe Price estimates you’ll pay 12% less in taxes during retirement.
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Savings no longer needed: People save an average of 8% of their income in retirement accounts like 401(k)s, according to the firm. During retirement, you’ll no longer be saving this money.
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Fewer expenses: T. Rowe Price assumes you’ll spend 5% less money in retirement.
By calculating how much income you’ll need to support your lifestyle in retirement each year, you can then find out how much money you’ll need to save in total.
For example, a person making $100,000 in the years leading up to their retirement would look to replace approximately $75,000. Assuming they collect $30,000 in Social Security benefits per year, the retiree would need other sources to generate $45,000 per year. Using a 3.8% initial withdrawal rate, the retiree would need $1.184 million in retirement savings (before adjusting for inflation) to potentially fund his lifestyle.
Customizing the 75% Rule to Your Situation
Of course, everyone’s financial situation is unique. Perhaps you’ve diligently saved for retirement throughout your career and are currently contributing 10% of your paycheck to a 401(k). Or maybe you plan to make even deeper cuts to your budget in retirement and will spend 10% less money than you currently do.
T. Rowe Price accounts for this variability.
“Every extra percentage point of savings beyond 8%, or spending reduction beyond 5%, reduces your income replacement rate by about one percentage point,” Roger Young, a certified financial planner and thought leadership director for T. Rowe Price wrote.
For example, saving 10% of your income in a 401(k) would lower your income replacement rate by 2% to 73%. Meanwhile, reducing your expenses by 10% instead of 5% would drop your income replacement rate to 70%.
Lastly, income level and marital status will affect your Social Security benefits – and in turn, your income replacement rate. For a high earner, Social Security will replace a smaller percentage of their income than it would for a person making an average salary. As a result, they’ll need to rely more heavily on savings to achieve their income replacement rate.
Social Security will also comprise a higher percentage of retirement income for married couples compared to people who are single. For example, a married couple with a dual income of $100,000 and 74% income replacement rate would see 36% of their pre-retirement income replaced by Social Security. This couple would need their savings and other sources to generate the remaining 38% of their pre-retirement income, according to T. Rowe Price’s analysis.
A single person with the same income and identical replacement rate would be in a slightly different situation, though. Social Security would only replace 28% of their income in retirement, meaning savings and other sources account for the remaining 45% of their money needs, the firm found.
“Understanding the income you’ll need from sources other than Social Security can help you estimate a savings level to aim for before you retire,” Young wrote. “At higher income levels, Social Security benefits make up a much smaller percentage of the total income replacement rate – meaning you’ll need more savings or other income sources to fund retirement.”
Bottom Line
Calculating your income replacement rate is an important step in the retirement planning process, but it doesn’t have to be overly complicated. T. Rowe Price says to start by assuming you’ll need to replace 75% of your income. You can then make tweaks based on how much you’re currently saving in retirement accounts, as well as how much less your spending habits will change in retirement. Doing some simple math can offer some important insights as you plan for life in retirement.
Retirement Planning Tips
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A financial advisor can guide you through the retirement planning process. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Do you know how much you’ll need to save to retire comfortably? SmartAsset’s retirement calculator can help you answer that question based on some simple inputs, including your age, income and when you’ll claim Social Security.
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The post How Much Income Will I Need to Replace in Retirement? T. Rowe Price Says Start With This Percentage appeared first on SmartAsset Blog.
Source: finance.yahoo.com