How to Estimate Your Retirement Expenses

Know What You'll Need to Live Comfortably

Couple sorting out bills

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Putting away your money for retirement can sometimes feel like you're aiming at a moving target. How much should you be putting away right now? How do you know when you have enough?

One of the biggest mistakes many retirees make is underestimating how much they will need to spend in retirement to have a comfortable lifestyle. They end up overspending because they didn't plan ahead or didn't know how.

It's a much easier task when you have an idea of how much you will need to maintain your standard of living. To determine how much money you will need to retire, you must estimate your retirement expenses. This is something you can do in a few simple steps.

How Will Your Spending Change?

A good way to begin to estimate retirement expenses is to use your current monthly income as a starting place, and then add and subtract any expenses you expect to change in retirement.

  • What is your monthly take-home pay? This is what gets deposited to you after all deductions for taxes, retirement plans, and insurance.
  • What expenses come out of your paycheck that you will have to pay out of pocket once you are retired (for example, health insurance)?
  • What extra expenses do you want to budget for during retirement? This would include things such as travel or extra money for health care expenses.

Be sure to build in monthly savings for items that will eventually need to be replaced such as major home repairs or automobile purchases.

It's also likely that you will see certain expenses decrease in retirement. For example, if you have a long commute to work, your transportation costs may drop after retirement. If you must dress for success at work, perhaps in retirement, your dry cleaning bill will decrease. If you pay off your mortgage before retirement, you'll cut out a significant monthly expense.

Adding It Up

Let's work through an example to see how this might work.

  • Current monthly take-home pay: $4,300 per month ($51,600 per year).
  • Expenses covered by your employer: Currently your employer pays for your health insurance premiums. You learn that once retired, you will have to pay $350 per month ($4,200 per year) for this coverage.
  • Extra expenses: You plan on traveling in retirement, so you budget an extra $500 per month ($6,000 per year) for travel.
  • Housing: Your mortgage will be paid off, so you'll only need to pay taxes and insurance on your home. That cuts out $1,000 per month from your spending.

After totaling those costs, you estimate that your total expenses in retirement will be $4,150 per month, which is $49,800 per year. Multiply that amount by how many years you expect to live in retirement, and you'll have a good starting target for your retirement accounts.

Take your time and be thorough with this step. It's easy to forget to account for certain expenses, whether it's annually occurring items such as real estate taxes and insurance premiums; medical expenses such as dental, eye care, and hearing; or periodic expenses such as home upkeep and auto repairs.

Estimate the Tax You Will Owe on Retirement Income

Unless your only source of funds is Social Security, it is likely you will pay taxes in retirement. You can use an estimated tax rate, such as 25%, which is better than not accounting for taxes at all. However to come up with an accurate dollar amount—and to set up your tax withholding or quarterly payments—you will need to do a tax projection.

A tax projection is an estimate that you do before year-end that shows you what your tax return will likely look like. Tax projection is important if you have mortgage interest, rental properties, or the majority of your retirement income will come from investments that are not inside of a retirement plan.

If you have pension income or the majority of your retirement income will come from qualified retirement plans such as IRAs or 401(k)s, and your home is paid off, your tax rate in retirement may be higher than you expect. Examples of pension plans include military retirement and payments from estates to which you may be the beneficiary.

Putting It Together

For the sake of simplicity, and to continue the example started above, we will use an estimated tax rate. Let's assume the person in our example will be in the 15% marginal tax bracket, and that most of their income will come from fully taxable retirement account withdrawals.

  • $49,800 / (1-.15) = $58,588

In the calculation above, dividing your net income by 1, minus your expected tax bracket, will tell you the amount of gross income you will need to pay your taxes and meet your other expenses.

This particular upcoming retiree has calculated that they will need about $58,600 of gross income per year to retire comfortably. For clarification, here is the breakdown of gross income, taxes, and expenses in the example:

  • $58,588 x .15 = $8,788 (estimated taxes)
  • $49,800 (living expenses) + $8,788 = $58,588

Once you have an estimate of how much you'll need to spend each year, you can move to the next step in the planning process and begin adding up your guaranteed sources of income so you can see how close you are to covering your expenses.