For many Americans, retirement feels like a far-off and distant dream. The most common age to retire in the US is 62 years old, which is also the minimum age to collect Social Security.
However, as demographics change in the US, Social Security will become less and less of a dependable, viable source of full income for future generations of retirees. It is of paramount importance that young people begin to plan and save for retirement sooner, rather than later.
There are several ways to predict and budget for the money you will need in retirement. Here’s how to estimate how much you need to save to live comfortably in your later years.
How much money do you need to live on after you retire?
The first step is establishing what your general living costs are and trying to adjust how much you will need to live on in retirement. The overall goal is to get a clear picture of how much you need, and then finding the sources of retirement income to match that result.
It’s hard to predict the future, but as a rule of thumb, most experts suggest that you will need 80% of the income you earn while working. That does not consider variables like healthcare, which can be a substantial cost in your later years. Some other factors to consider are:
• Monthly housing costs (mortgage, rent, or assisted living)
• Transportation expenses
• Food, clothing, and personal care
• Taxes and insurance
• Other travel and entertainment
• Family care (helping your children or grandchildren)
According to the Employee Benefit Research Institute, almost 50% of families end up spending more during retirement in comparison with their working salaries. Nearly one-third of families surveyed actually spend 120% more than they did while working. In retirement, many families have the time to enjoy traveling, buy a second home, or spend money on entertainment they otherwise wouldn’t while working.
Taxes and Retirement
Taxes will also play a role in how you budget for retirement. There are tax implications when you withdraw from retirement investment accounts like the 401(k) or a traditional IRA. Taking money out of your 401(k) means the money will be taxed as ordinary income based on your tax bracket.
Retirement taxes don’t end at the 401(k) investment. There are also Social Security benefits taxes. If your income is above $25,000 for singles and $32,000 for married couples filing jointly, federal taxes apply to Social Security benefits. The tax rates depend on your tax bracket and your state’s tax rules – 13 states tax Social Security, each with their own rules. The best way to estimate your future tax rates is to research what taxes your state imposes, plus your current federal income tax rates to get a rough estimate of what you can expect to pay. It’s also worthwhile to consider switching to a Roth IRA account if you’re at least five years from retirement.
The Impact of Healthcare Costs
Bottom line: healthcare in the US is expensive. Many adults underestimate how much money they will need to save for healthcare in retirement. In 2018, Fidelity Investments estimated that a healthy, 65-year-old couple would need $280,000 to cover their healthcare costs in retirement. This figure included “premiums, cost-sharing provisions and out-of-pocket costs associated with Medicare parts A, B, and D,” but not “other health expenses such as over-the-counter medications, most dental services, and long-term care” or any employer-sponsored retiree health coverage.
Often, seniors assume that Medicare is free and will be enough to cover their healthcare costs. However, Medicare premiums can be quite high. Social Security considers some individuals to be a “higher-income beneficiary,” meaning they pay higher rates for Medicare Part B, the health-insurance portion of Medicare. In 2017, higher-income beneficiaries were individuals who made $85,000 or married couples filing jointly who made $170,000.
Estimating Your Sources of Income
As soon as you have a figure of what you need to live comfortably in retirement – including day-to-day living expenses, your predicted tax bracket, and some extra funds for healthcare costs – it’s time to find the best investment sources for your retirement fund. This means understanding what you can expect from pensions and Social Security, as well as your own personal saving goals. Here are some of the vehicles for saving for retirement you may consider.
If you work in the private sector, it’s rare to have a pension; government organizations may offer a pension plan, as well as a handful of large companies. If you do have a pension, the way that it works is the employer contributes money into your pension plan for as long as you work for them. When you retire, that money is then paid back to you in the form of a monthly check. The amount you will receive depends on a formula that considers the number of years you worked for the company, your age, and your salary. Pension benefits are taxable.
Most companies don’t offer pensions, but they do offer 401(k) plans. A 401(k) is a way to avoid paying income tax in the current year on the amount of money you put into your retirement account. The employer makes contributions to the 401(k) as well – either by matching the amount you contribute, putting in a set percentage, or using a profit-sharing formula that bases their contribution on the company’s success.
A “salary deferral contribution” is the amount you add to your 401(k) each year to save for retirement. This contribution is tax-deferred, meaning as you earn investment income, you don’t pay tax on the annual investment gains. As mentioned previously, you will pay income tax on the amount you withdraw during retirement. If you withdraw from your 401(k) too early, you’ll pay a 10% penalty tax on top of your income tax.
Like the 401(k) is the IRA, or individual retirement account. There are two main types of IRAs: Roth IRAs and traditional IRAs. These accounts hold retirement savings with some tax benefits that depend on the type of account you open, with contribution limits, early withdrawal penalties, and other implications that you must research ahead of time.
Finally, Social Security benefits are guaranteed income the government raises from your taxes. The amount you receive will depend on the amount of Social Security taxes you paid, with wages adjusted for inflation (this is your Average Indexed Monthly Earnings, AIME). There’s a tool that helps estimate your Social Security benefits on the organization’s website. Remember, this estimated Social Security benefit is primarily based on your salary; adjust your expectations depending on how far you are from retirement.
If you’re worried about saving enough for your retirement, talk to the experts at CPA Services to get recommendations on the best investment plan for you and your family.