When planning for retirement, an important factor to consider is your desired standard of living. Do you hope to maintain the same or a similar lifestyle? If so, how much money would you need to do so? To find out, it is helpful to establish your projected replacement ratio in retirement.
Your replacement ratio is the percentage of your pre-retirement income needed to fund your retirement years. You can estimate your retirement replacement ratio by dividing your projected gross income after retirement by your gross income prior to retirement.
So, do you need 100% of what you are making to maintain the same standard of living? When determining what you need, keep in mind that the following changes may lower your overall living expenses in retirement:
• Lower Income Taxes – Your taxable income usually goes down, if it does you pay less in taxes. In addition, after the age of 65 you may be eligible for additional tax deductions. Again, this lowers your overall tax withholding. However, the higher your income in retirement, the higher your tax rate will be.
• No Social Security/Medicare Taxes – If you are required to pay Social Security or Medicare, you will no longer be required to pay these taxes. This is a savings of approximately 6.2% if you were paying into Social Security and 1.45% if you were paying into Medicare.
• Saving for Retirement Ends – All deductions and contributions you were setting aside for retirement will end.
• No Work-Related Expenses – You will no longer spend money on items associated with work such as work clothes, fundraisers, or commuting.
Experts recommend a replacement ratio of 70% to 90%. However, you must also consider the possibility of increased costs associated with inflation, longevity and healthcare. Entertainment expenses may also increase because many retirees spend more time traveling and pursuing hobbies and leisure interests.