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Building a retirement budget can feel like an overwhelming exercise. You may want to move to a lower cost of living area or a state with no income tax post retirement. You must plan for a different stage of your live that will involve different needs around medical costs and who knows what else. If you’re retiring very young, you may need to budget for additions to the family down the road.
How do you make a plan that involves living in a place you’ve never lived, with needs you don’t currently have, and possibly with people who have yet to exist?
There is a simple strategy.
While you have never lived through these things, there are millions and millions of people who have. What you need is an empirically based budget.
The Empirically Based Budget
Time Commitment: 2.5 Hours
Start with a laundry list template for your budget. It’s important to start with a master template rather than trying to create one from memory because you are likely to forget important expenses or be unaware of expenses that will occur in a future stage of life.
For example, when I was working my company paid for my cell phone plan and my health insurance premiums, but I need to think about those myself now. Or perhaps you rent now, and so you wouldn’t think to include home insurance or sewage and garbage fees for when you own a home of your own.
Here’s a template I like created by BlackRock. If you click on the image, you’ll actually be able to enter your estimates in the sheet directly and it will do all your calculations for you. (02/2017 Edit: Looks like they’ve pulled it down planning to update it, will leave the link up in case the new version comes online and is usable).
Budget created by Blackrock
Ongoing vs One-Time
Notice there are two key sections. There are ongoing expenses which you see every year. There are also – and this is the category most people miss – one-time expense you would like to set aside capital for. Here are the major one-time expenses you might be considering:
- Purchase of a Home
- College Tuition for Kids
- Large Medical Procedures/Surgeries
- Nursing Home or Assisted Living Expenditures
- Replacing Cars If Not Leasing
- Care For a Family Member
- Large Vacation (50th Anniversary, Retirement, etc.)
- Major Home Replacements (Roof, HVAC system)
It’s important to try and capture as much as you can in one-time expenses rather than adding buffer in your ongoing expense budget. This is because needing to provide an ongoing cash stream is much more difficult and will cause you to overestimate your nest egg needs, possibly by hundreds of thousands of dollars.
Go ahead and customize the categories for yourself.
Once you have the right categories locked in, it’s time to leverage the wisdom of those who came before you and gather data for each category.
Taxes: I like to use SmartAsset’s tax calculator for these estimates. You may need to wait until you have an estimate for all of the rest of your total annual expenses. You would then take your total annual expenses solve for it using SmartAsset’s calculator. Of course, this assumes you are generating income that’s taxed at ordinary income rates. If you’d like to implement a totally legal strategy to pay zero taxes, that’s an option, too.
Household: You can use your own knowledge of your current area if that’s where you plan to stay. For those who are planning a move to a different city post-retirement, this is where the internet is your friend, and can help you gather empirical data from others who have done this before you.
- Clicking on a few Zillow properties in your new area will give you a sense for what property taxes and a house in your desired neighborhood will cost.
- CityData forums are excellent for getting a sense of what utilities will cost. Googling “average electricity/gas bill for family of four (city)” will probably take you there.
- You can get home insurance quotes from any major insurance engine or by Googling “(city) home insurance quotes”
Living Expenses: You can probably use your own current expenses for a rough estimate here. If you are moving to a significantly lower cost of living area you can check out a COL comparison tool like the one at Bankrate. I prefer the tool at Bankrate to other popular sites because it actual shows sample item comparisons rather than giving you a high level percentage estimate by category. It gives you the data to make your own estimate.
Insurance: This is where you want to go heavy duty research as insurance costs can be drastically different depending on where you are in the country. Search on at least one private health insurance marketplace like eHealth in addition to HealthCare.gov. Private marketplaces will show you plans that are not available on Healthcare.gov and, conversely, they do not include all the options available through Obamacare.
Note that your insurance costs will climb rapid as you age into your forties and fifties. To create more granularity you could do two budgets to model what your expenses look like at different stages of retirement. For myself, I just picked roughly the highest point for insurance cost and used that as the estimate.
Family Care: Same strategy as above. If you plan to support your kids in a sport or extracurricular, look up the cost of a couple sample activities via yelp (i.e. look up taekwondo dojos or music teachers and visit their websites for pricing).
Discretionary: Don’t fix what ain’t broken – continue visiting websites for pricing in as many categories as you can. For vacations, you can put in a set amount you spend per year or if you only go on a big vacation one every few years, you can divide it into annual contributions to the vacation.
Your research here is going to be paramount. Just like in other categories, search on forums and in magazine articles for the typical costs for your one-time costs. Plan to send your kids to a public university? UC Berkeley in CA estimates tuition at $13k a year and $26k a year if you include room and board. Are you living in Wyoming? Visit the University of Wyoming’s website to learn that tuition is a little over $3k a year and total annual costs are currently $13k when including room and board.
A note on your one-time expenses: don’t panic. You may add up those expenses to an eye-popping number.
Keep in mind, though, that you only need a seed amount rather than the full amount before you retire: you may have years until the big expense comes, and your money will be working for you in the interim to grow towards that target.
For example: Say you would like to pay for your kid’s college tuition. You want to conservatively save up $52k (adjusted for climbing inflation) for four years of tuition, room & board at the University of Wyoming. But your child is five years old, which means you have 13 years before you need to start ponying up the cash. You want to work backwards to get to a seed amount you must save. This is illustrated below.
Estimated Annual Growth Rate (in a tax-sheltered 529 college plan): 6% nominal. Since inflation tends to be around 2%, that implies a 4% real growth rate
You will want to use the real growth rate which factors in the presence of inflation as tuition is probably going to climb by inflation in the coming years as well.
- Seed Amount * Real Growth Rate^Years = Target $52k
- Seed Amount * (1.04)^13 = $52k
- Seed Amount Needed = $31.2k
Retiring with an extra $31.2k is a lot more manageable than expecting to have the whole $52k amount saved up. Let your money do some of the work for you.
You can use this same exercise in calculation your other one time expenses. What you will need is 1) the number of years the dollars can work from you from time of retirement to the time you actually have to pony up the cash and 2) an estimate of what the growth rate will be excluding inflation.
For one-time expenses, you should enter the seed amount which will grow over time, not the final target amount it will actually cost.
Here is an example of a filled out budget. This contemplates a super-mega-awesome luxurious life in Austin, TX well above the average standard.
Note that our hypothetical family pays zero in income tax. That is a legal, completely realistic assumption which you can read more about here.
- To fund this amazing lifestyle, we would need to have a nest egg that can throw off $59,722 a year as well as an additional $670k to fund our one-time expenses
- Using the 3% safe withdrawal rate, you would need $59,722/.03 = $2 million to fund ongoing expenses plus an additional $670k for one time expenses. Your total nest egg target for this budget is $2.67 million.
“$2.67 million,” you say, “that’s insane!”
I agree. Welcome to the trade-off of luxuries vs time. You could slave away until you’re 70 trying to reach this $2.67 million figure, or you can go back to the drawing board and revamp the expectations that can make you happy.
For one thing, notice that discretionary spending makes up ⅓ of my entire sample budget. If I eliminated all of those things, I would need $678k less!
You may not want to contemplate a retirement with a zero dollar entertainment budget, but there is room to trim here, and it is comforting to know that if your portfolio has a particularly bad year, you can decrease spending temporarily by cutting into these discretionary amounts. Secondly, maybe you don’t need that extra $200k of buffer, or a $400k house when a $300k house will do.
You now have a well-researched first stab on paper. You are ahead of 95% of the population!!
Now plan to iterate a few times on your budget – it is a living, breathing document that is meant to help you understand your priorities. The most valuable part of the budgeting exercise is in the iteration stage, because it will help you learn what things are truly important to you and what things you didn’t put much thought into and can trim now that you see the impact it has on your target. There is nothing like have numbers concretely on the page to help you rethink your priorities.
I hope that the two and a half hours later you spend are this are extremely valuable ones as they were for me. Not only will they help you sharpen your focus on your goal, but it will also help you understand your values and priorities. How much do you want to retire? Is retiring a year earlier worth driving older cars or going on a vacation every other year rather than every year?
I’m interested in what the exercise helped you uncover. Share your thoughts in the comments below.