What will your income and expenses be in retirement?
Begin the process by listing your anticipated expenses as well as your sources of income in retirement, which might include pensions and annuities, Social Security, savings and a business. Then look at your anticipated expenses, dividing them into three buckets — essential (fixed expenses like food, housing and healthcare costs), important (funding education costs for family, planning a legacy) and aspirational (travel, hobbies, a vacation home). Leisure spending is generally considered aspirational.
Essential expenses will require predictable sources of retirement income, because they’re by definition not optional and it’s unlikely you’ll be able to reduce them substantially. After you have a strategy for covering those, move on to the other two categories. You’ll probably have more flexibility in the costs for the “important” items on your list and when you’ll need the money. Remember, too, that some costs, for things like commuting and clothing, might decline.
Once you’ve done that, your financial advisor can help you align your resources and investments with each one of the buckets, Storey says. When investing for aspirational items, you may want to take on more risk than you might for the essential and important items. And keep in mind that taxes are going to take a chunk out of your income. “We look at our retirement accounts and just say, for example, ‘I have $1 million,’” Storey says. “We don't say, ‘Actually, I have about $750,000, because 25% is going to go toward taxes.’” Pre-retirees often underestimate the taxes on tax-deferred accounts like traditional IRAs and 401(k)s, he notes. Your advisor can help you determine how much and when to withdraw from each account in order to minimize taxes as well as allowing the funds to continue their potential for investment growth.
How much will you need for leisure spending?
Next, create a rough estimate of what you think your leisure activities are likely to cost (for a look at the potential price tag of some common leisure activities, see the slideshow above). Your expenses are likely to change over the course of retirement, with leisure spending decreasing over time, Storey notes. When the Employee Benefit Research Institute analyzed the spending patterns of older Americans, they found that out-of-pocket healthcare spending rose with age, while transportation, clothing and entertainment spending all declined.7