It’s not always easy to think about retirement when the challenges of daily life intrude. But retirement preparation can help focus you on the long-term rewards of planning ahead. It starts with understanding some basic concepts of spending.
Throughout your career, cash flow is straightforward: you work and get paid a steady salary through an employer. But that all changes once you retire. Your income channels suddenly switch, and with it, the amount of money you can spend.
Spending money is easy, but spending it wisely takes a diligent and strategic plan to maximize your best retirement life. Let’s look at some better ways to spend money in retirement.
Understand Your Income Channels
Money flows differently in retirement. It’s important to know all your monthly income channels and how they work together to support financial and lifestyle goals.
Instead of several checks per month from your employer, you should look at the different ways you might receive income in your golden years:
- Part-time work/Encore career
- Social Security
- Retirement accounts (401(k), Traditional IRA, Roth IRA, etc.)
- Investment portfolio
Knowing where your money will come from is essential to building a spending plan that makes sense for your income level and post-career goals. This will help you think strategically about how to maximize the money you do have in balance with your lifestyle needs.
Use Your Portfolio
Your investment portfolio has been a wonderful tool to support your retirement goals. Once retired, you’ll need to think about how you want to use the assets accumulated in your working years. Here are two popular approaches that might work for you:
1. The 4% Rule
The 4% Rule is a guide for structuring withdrawals from your portfolio. It advocates pulling out 4% of your portfolio the first year you retire, then withdrawing the same amount in subsequent years (factoring in inflation). For example:
If you retire with $1 million dollars, 4% equals $40,000 ($1,000,000 x .04). Using the 4% Rule, you would withdraw the same amount the following year while factoring in inflation (which for this example we’ll make 2%). This leaves you with $40,800 ($40,000 x 1.02). You would continue to follow this structure each year.
The 4% Rule has been popular with advisors and investors alike, but it’s not without its concerns. Critics point out the 4% Rule is rigid and unable to meet the diverse needs of unique investors. For some retirees with a wide asset array, the 4% Rule’s approach might be too conservative, leaving a lot of money on the table. For others, the rule may be too aggressive depending on the structure, asset location, and asset allocation of the portfolio.
It’s also important to understand how the 4% Rule originated. It was created to cater to a certain type of portfolio over a long period of time. In general, it favors a split portfolio of 50% stocks and 50% bonds. While some investors may have that split, others don’t due to factors of risk tolerance, evolving investment goals, and time horizon.
The 4% Rule does assume a 30-year retirement horizon. While many people are living longer, they’re also retiring later which may impact their situation. Be sure to factor in your retirement time horizon to maximize the money you’ve saved and invested over the years.
While the 4% Rule may be a good starting point, it isn’t the only consideration for your distribution structure. As you work with your financial advisor to create a suitable plan for your needs, be sure to think about:
- Changing risk tolerance as you move into and through retirement
- Your retirement timeline horizon
- Investment goals throughout retirement
- Asset allocation, asset location, and portfolio diversification
- Tax implications
- Retirement financial goals
- Retirement lifestyle goals
2. The Multiply By 25 Rule
Unlike the 4% Rule that focuses on how much you should take out of your portfolio, the Multiply By 25 Rule emphasizes how much money you need to live your best retirement life. It works by multiplying your desired annual retirement income by 25.
Let’s say you want to spend $50,000 per year in retirement. Following the rule, you would need $1.25 million dollars in your portfolio. In essence, this rule helps estimate how much you’ll be able to withdraw in retirement based on your starting asset number.
It’s important to know this rule doesn’t take into account Social Security, pension, annuity, or other income.
The Multiply By 25 Rule gives you a decent starting point, but to sustain your ideal lifestyle throughout retirement, there’s another essential tool to pair with it: a healthy budget.
Create a Realistic Retirement Budget
Budgets aren’t the most exciting tool but they are important for the organization, management, and preservation of your money in retirement. If you haven’t made a budget yet or your existing one needs tweaking, take time to evaluate where, how, when, and why you spend your monthly money.
Where you spend money…
- Housing (rent, mortgage, etc.)
How you spend money…
- Within budget
- Over budget
When you spend money…
- Consistently month-to-month
Why you spend money…
- What drives you to spend money?
- Are you spending money intentionally?
- Is your spending aligned with your goals and values?
These factors can help you see your budget in a more nuanced way. You can assess each category and figure out if your budget makes sense, and how to tailor it to your overall goals and needs.
If you set a grocery budget for $150 per week but regularly spend $200, increase the budget number you set and find other places to cut back.
Creating a strong retirement budget is all about balance to honor your goals and priorities in life.
Plan for Increased Healthcare Costs
As healthcare costs rise, retirees must reflect them in their retirement spending plan. A Fidelity study found a couple can expect to spend $285,000 in healthcare costs over the course of their retirement, and that’s just the beginning.
When you factor in inflation, long-term care costs, insurance, nursing, hospital stays, and prescriptions, it becomes daunting. It’s essential to have a strong savings plan in place for your healthcare costs in retirement.
One way you can prepare is by investing in a health savings account (HSA). This account lets you contribute pre-tax dollars while all gains grow tax-free (and the distributions remain tax-free as long as they’re used for a qualifying medical expense). HSAs are often associated with high-deductible healthcare plans, so look at your plan to see if it supports HSA contributions.
New retirees will also need to familiarize themselves with Medicare. Medicare is a complex system, so working with a professional to help ensure you enroll in the right plan will be a big help in the long run. A professional will also help you understand any deductibles, premiums, co-pays, co-insurance, or other payments you have questions about.
Pay Down Big Debt
For many retirees, debt can be a major roadblock. It can impact and restrict cash flow, which can negatively affect your lifestyle. Creating and sticking to a debt-repayment plan will free up your cash flow and make your retirement spending more flexible.
Take your mortgage payment: paying off your house before you retire allows more freedom in your retirement budget. Big debts like this can be such a major headache in retirement that it might be worth it to work a little longer until it’s paid off. Be sure to weigh how much you still owe and the impact it will have on your post-career cash flow.
Other big debts to consider paying off before retiring:
- Auto loans
- Student loans
- Credit card debt
- Personal loans
Paying off debt lets you take control of your finances and spend money in a way that best fulfills your lifestyle goals.
An Advisor Can Help
Structuring a retirement spending plan is a nuanced process that balances investing, taxes, income, goals, and more. Working with a professional will ensure you get the comprehensive advice needed to create a plan that reflects your values throughout your golden years.
We are passionate about helping people live the retirement they’ve always wanted. Our team of advisors are ready to help you create a future that emboldens your unique needs. Ready to get started? Schedule a consultation today!