Our firm holds regular educational classes at the community college campus near our Ankeny, IA office. We invite folks in surrounding communities to these classes through direct-mail postcard invitations and digital invitations through Facebook. The invitations highlight several specific topics that we commonly cover during our classes. For example, strategies to optimize entitlement programs such as Social Security, and specific actions to take that may reduce taxes in retirement.
However, each class is very different from another. They seem to take on a life of their own. This is because we begin each class by taking questions from the attendees. Within the first 5 minutes of class we list no fewer than 5 questions that the folks who joined us that evening are hoping to get answers to. Then, we do our best to address each question as thoroughly as possible in the remaining 70 minutes that we are together. Attending one of our classes doesn’t mean you have attended them all!
I Heard I’ll Need Less Income in Retirement, Is that True?
At a recent event, a man sitting next to his wife in the back of the room asked a fascinating question. He said, “I have heard that I’ll need less income in retirement than I do during my working years. Is that your experience working with the folks you serve?” Frankly, we’d never been asked this one before during one of our classes.
I was delighted when he asked such a question. My face lit up, and I was beaming with enthusiasm. In fact, I love it when our students engage in meaningful conversation seeking thoughtful insight. It’s not every day we get one like this either. It truly was a teachable moment for all in attendance, and that is what are classes are all about.
I began by responding to his question with a question. “Sir, what day of the week do you tend to spend the most money?” There was a short pause. Then suddenly, “Saturday,” his wife shouted.
“Correct,” I said. “For many folks, Saturday is the day they tend to spend them most money, and when you retire everyday seems to be a Saturday.”
I went on to point out that most folks tend to spend less during the weekdays throughout their career because there at work. Their time is overwhelmingly occupied making money, not spending it. However, on the weekends when they have more free-time they tend to spend more. When you are retired, it’s likely you’ll have more free-time. The leisure time tends to result in additional spending. At least in the early years of retirement.
A Better Questions Might Be….
Looking back on the exchange, perhaps I should have provided our guest with a suggestion for a more constructive question that he could be asking.
“Will my spending decrease or increase when I transition into retirement.”
A subtle difference yes, but a significant one at that. He asked about income and will it be less, but what he should be focusing on is spending and will it be more?
Many folks who attend our classes earn more income than they need to sustain themselves and keep the bill collectors at bay. During their working years they have a surplus of income; some more and others less. Some choose to place their excess income towards their savings accounts in preparation for a future free from financial concern. Therefore when we ask a question like, “Will their income be less in retirement?,” …for many the answer is likely to be “yes.”
Asking whether your spending will change is a whole other question, and a more constructive one when preparing for retirement. This is because your spending reflects your lifestyle. Where you live, what you drive, the clothes you wear, what type of food you put on your table, where you vacation, which hobbies you enjoy and so much more influences your spending habits. I’ve not yet met a couple who told me that they would prefer their lifestyle to decrease once retired.
Understanding your desired lifestyle is paramount when planning for a smooth and successful transition into retirement, and it needs to be a focal point.
- How much does it cost to maintain it today?
- How much should we anticipate it to cost in the future when adjusted for inflation?
- Are your retirement resources sufficient to support it?
These are all better questions to ask than whether or not your income will be more or less in retirement, and I think this is what our friend from class was really asking.
Missing the Mark By 20% to 30%
What we have found is that retirement spending assumptions are often short by 20% to 30%. Meaning that folks are grossly underestimating how much they will need to spend in retirement in order to maintain their pre-retirement standard of living. The research conducted by various financial institutions and think tanks concur. When polled, folks who are already retired routinely report having underestimated what they will need to spend in order to maintain a desired standard of living.
Why is this so consistent across the board? It seems to result from failure to acknowledge all expenses retirees will face in retirement. There are two significant expenses in particular that we see overlooked frequently, and I think they make up the bulk of the problem. The reason these two expenses are so often overlooked is a direct result of the way W2 employees are compensated and how payroll is handled today.
Payroll Deductions Seem to Be the Culprit
Most workers in the United States are W2 employees. When you work as a W2 employee, trading your time or expertise for a paycheck, your employer is responsible for payroll duties. What you receive by check or ACH to your bank account is net spendable income. W2 employees tend to design a life around this, and forget about what has already been taken out of the equation.
What are two realities of retirement planning expenditures that are not included in the afore mentioned net spendable income of our W2 employee? Perhaps a better way to ask it is, “What two-line items have already been deducted when the paycheck hits your account that you will be responsible for in retirement?”
Prior to the cash hitting the checking account customarily both TAXES and HEALTHCARE have been subtracted from our W2 employee’s gross pay. Retirement savings may also be deducted as well, but that is not an expenditure that one can expect to continue to incur in retirement. In fact, one will be drawing on savings instead of contributing to it. What the employee receives after these deductions is net spendable income. Net income is free to be saved, consumed, or shared. It’s theirs to use as they see fit.
However, when you retire and begin to distribute assets, in particular pre-tax retirement savings, taxes and healthcare have not been deducted from the gross amount. Taxes and healthcare cost can quickly increase a spending plan by 20%-30%.
You’ll Spend More Than You Expect
Let’s say for example a married couple filing taxes jointly have determined that in order to maintain their current lifestyle they’ll need $8,000 per month. About $8,000 per month is what they have become accustom to spending on goods and services over the last few years, and this is what they tell their financial advisor that they’ll need to produce from their retirement resources. Of course, they’ll have to adjust for inflation throughout retirement in order to maintain their desired standard of living, but for now we’ll just focus on the current need.
We’ll assume that their combined household Social Security benefit brings in $4,000 per month. That covers half of the monthly spending they think they’ll incur. Therefore, they need to withdrawal an additional $4,000 per month from their retirement savings, or $48,000 per year, to compliment Social Security in order to maintain their lifestyle.
If they are like many near-retirees, the overwhelming majority of their retirement savings are held in pre-tax accounts. For example, IRAs, 401Ks, or other IOUs to the IRS are the primary retirement savings account for most people preparing to transition into retirement. Therefore, when our married couple distributes funds from these accounts they will be responsible for state and federal income tax.
To keep it simple we’ll estimate that their combined state and federal obligation on the distributions is about 15% total (5% for state and an effect federal rate of 10%). If they need an additional $48,000 they will have to withdrawal nearly $56,500 gross. About $8,500 will go to pay the tax on the distribution from their pre-tax accounts. Ouch!
Now let’s add in healthcare expenses. Combined household Medicare premiums and supplemental insurance could easily add an additional $600 to $800 per month to our couple’s spending plan. We’ll split the difference and call it $700 per month for them, or $8,400 for the year.
Where’s this additional money going to come from to pay for healthcare? Oh, yeah! Their IOUs to the IRS. More pre-tax account distributions mean more taxes to pay! They’ll need to add another 15% to the healthcare spending in order to settle up with the government. The $8,400 distributions to cover their healthcare spending grossed up for taxes is closer to $9,900, or about a $1,500 difference just to pay for the triggered taxes.
If you add it all up, the estimated healthcare expenses ($8,400), and estimated taxes ($10,000), we’ve just added nearly $20,000 to their spending plan. That about 20% more spending than this couple had expected. Its 20% they never even thought about building into their income need when they told their advisor they needed $8,000 a month.
We didn’t even get into the discussion on how much of their Social Security benefits will be subjected to tax as a result of their pre-tax account distributions. Their provisional income will be pushing $90,000 so this married couple could expect to pay additional taxes on 85% of their social security benefits.
A Comprehensive Written Retirement Plan Must Include A Spending Plan
There’s a reason we ask all of our clients to complete a spending plan when we initially develop their written retirement plan. We’re not trying to be difficult or oppressive. Quite the contrary. We want to free them to enjoy their post retirement years with confidence. We care enough to get the nitty gritty details dialed in.
We know our written plans are in accurate the moment the income dries. After all, rates of return will vary, tax rates may change, and inevitably lifestyles will shift over time. However, if we take the time to get serious about the details in the beginning we can manage small seemingly insignificant adjustments annually, and likely avoid uncomfortable “oh-shoot” moments resulting from sloppy organization and poor planning. We aim small, we miss small. That is our motto.
The folks we serve are wanting us to help them design a retirement lifestyle using the resources they’ve accumulated. One that is at least on par with their pre-retirement lifestyle. In order to accomplish this we need to know what it cost to maintain their desired standard of living today so we can help them be better prepared to support it into the future. Once we get our arms around the cost to maintain their lifestyle, we can adjust it for inflation, inevitable taxes, and the rising cost of healthcare.
If you have not completed your own spending plan we’d encourage you to do it sooner than later. It can be a great exercise for spouses to complete together, and helps get them on the same page plotting a realistic course going forward. You’re welcome to use a copy of our spending plan to get started. You can download a complimentary copy here. Enjoy!