Millions of women approaching retirement age have nothing saved up and depend on Social Security alone. Other women are worried of what will happen to them because they will retire with a small balance in their retirement account.
If you are a reader of this blog, it means you take preparing for retirement seriously and want to learn more on the topic.
When I think about planning for retirement I think about it like assembling the financial pieces of the puzzle. It takes time before everything fit into the right places and you can see the whole picture.
The important part of this process is to calculate your retirement income and expenses and see if you have a gap between them.
Why identifying an income gap is important?
When you retire, you can no longer count on a paycheck from work. You will start relying on a fixed income, such as Social Security or pension. But the income from these sources may not be enough to cover all your regular expenses.
That will leave you with the gap between income and expenses. In this situation, you will depend on money from your savings and retirement accounts to cover the expenses.
Let’s find out how much is your income gap in 5 easy steps.
Step 1. Review your current financial situation
You need to see where you are right now and what do you have. Take an inventory of all your financial assets.
Start by collecting all your financial information:
- How much is the current value of your house?
- How much do you have in your retirement accounts, 401(k), IRA, Roth IRA?
- How much do you have in your investment accounts?
- How much is the current value of your rental property or vacation house (if you have one)?
- How much is the value of your collectibles, gold coins, if you have any?
If you want to know the current value of your house, use Zillow for an approximate estimate.
Recently we refinanced our mortgage and it came with an appraisal report. I use this estimate as the approximate value of our house. You can ask the local real estate broker to give you the most current evaluation of your home, your rental property or a beach house if you have any.
Put all this information in the Excel spreadsheet or just use a piece of paper and call it Financial Assets Category.
Step 2. Estimate your retirement income
The next step will be to find out how much is your combined retirement income.
The income in retirement will come from different sources.
For many people, a Social Security paycheck will be THE ONLY income in retirement.
Other people will have an additional income coming from savings, retirement accounts, annuities, rental properties and/or dividends.
The more sources of retirement income you have the better off you are in your golden years.
Collect all this information and add to your Excel or paper spreadsheet under the Retirement Income Category.
Most of the information you have already collected while taking inventory of your financial assets. You just need to add the amount of your Social Security benefits.
Use the link to the Social Security Administration for information.
Related Post: What is the source of your income in retirement?
Step 3. Estimate your retirement expenses
There are many ways to estimate expenses in retirement.
A simple way to estimate your retirement expenses is to know where and how you spend your money today while you are still working.
Grab all your bank and credit card statements, your bills and any other financial information you have and calculate the total. This total number shows your monthly expenses today. The hard part of estimating retirement expenses is to predict how it will change in 10 or 15 years.
A common rule of thumb to use is that you will need about 70 to 80% of your current spending.
Here is a simple calculation.
If your current spending is $5,000, in retirement it will be approximately $3,500 to $4,000.
But if you are planning to maintain the same lifestyle as today, or splurge on a lot of travel trips or have expensive hobbies, your retirement expenses will be $5,000 or even higher.
Related Post: Why predicting retirement expenses is important?
Step 4. Calculate the balance between income and expenses
Finally, you collected all the information and have the full financial picture in front of you:
- Inventory of all your assets
- Your retirement income
- Your calculated expenses
The next step will be to calculate the balance between your income and expenses.
Did you find out that you have an income gap in your future budget? If yes, how do you cover it?
Here is a simple example.
You are planning to spend in retirement $5,000 a month ($60,000 a year).
Your guaranteed income from Social Security and/or pension is $4,000 a month ($48,000 a year).
$5,000 – $4,000 = $1,000
Based on the calculations you have an income gap of $1,000 a month ($12,000 a year)
Step 5. A few ways to cover a retirement income gap
How do you cover the retirement income gap?
- Reduce your spending in retirement
- Plan to work longer, so you can save more
- Delay to collect Social Security to increase the future pay
- Withdraw money from savings and retirement accounts
Even you are planning on working longer, to save more and delay Social Security might be still not enough to eliminate the gap completely.
According to statistics the average retired worker will receive around $1,360 per month. And the average retired couple will receive $2,260 per month. These numbers are adjusted with every year and not to the higher end.
The idea of working longer, saving and investing more becomes important when we look at the statistics. For many of us, the Social Security check will cover some of the basic retirement expenses.
However, if we want to maintain our current lifestyle or dreaming about active and fun years in retirement, we need to know how we will cover the gap between income and expenses.
How much money to withdraw from retirement accounts?
You have built a good size nest egg to live off it in retirement. After you retire and stop receiving the paycheck from your employer, you will start spending your retirement savings to cover the expenses. You need to be careful about how to withdraw money from your retirement savings.
The popular rule of thumb is 4 percent or “safe withdrawal rate”.
Its recommended by many financial planners and advisers. There are many debates between financial professionals if 4 percent is safe enough. Some of them recommend to reduce it to 3 or 3.5 percent. The main idea is you should be able to withdraw 4 percent of your portfolio value without ever depleting it to a dangerous level.
In what order to withdraw money?
When you retire, you get to decide how much to take from your savings and retirement accounts and in what order. The order in which you withdraw money from your accounts can impact how long your portfolio lasts in retirement.
In general, you should withdraw money in this order:
- First – from taxable investment accounts
- Second – from tax-deferred accounts – 401(k), IRA
- Last – from tax-free accounts – Roth IRA
The reason behind this order is how much you must pay in taxes. Taxes will likely be one of your largest expenses in retirement. You will have more control over taxes, if you will be smart about withdrawal strategies.
The longer you can keep money in your tax-deferred and tax-free accounts, the better. It means that more money stays in your accounts and grow over time.
Everything will change once you reach 70 ½. At this age you must start taking money from your tax-deferred accounts based on IRS rule.
The rule is called a required minimum distributions (RMD) and it cannot be ignored, otherwise, you will get penalized.
So, if you are 70 ½ years old the order of money withdrawals will change:
- First – withdraw your required minimum distribution (RMDs) from a combined balance in retirement accounts
- Second – if you still have an income gap, pull money from taxable investment accounts
- Third – if you deplete the taxable accounts, go back to your tax-deferred accounts
- Last – pull money from tax-free accounts
Final thoughts
You’re in good shape, if you can stretch your financial assets to create enough income to cover basic expenses in retirement. But if not, you’ll need to find additional ways to increase your income or reduce your spending.
Even if you think that you’re far away from retirement age, you might still consider some of the options above. The main reason we are saving money for retirement is so we can spend them when the time comes. To learn and prepare yourself and your finances for the future is better than to ignore it.
This post is only for educational purposes and serves as a guideline for the readers of this blog who wants to learn about retirement planning. Please don’t rely on it as a tax or investment advice.
Did you come up with the numbers for your retirement income and expenses? Do you have an income gap?
Have you started thinking about how to withdraw money from your savings and retirement accounts?
Please share your thoughts with us.
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