Understanding your likely expenses in retirement is critical to planning for retirement/financial independence. If, however, you have ever been baffled by what “expenses” to include when using a retirement calculator, join the club. True enough, as explained in my article on how to develop your own plan for financial freedom-your plan to Catch FIDough-you must understand your spending. You must also understand what you will likely spend after you retire or achieve financial independence. (So, if you are not yet tracking your spending, sign up for FIDough’s favorite spending tracker Personal Capital which will also help support FIDough and its charities.)
But “expenses” is too ambiguous because we know that our expenses will change. A better way to think about the problem is to think about the income that you would like to have available after you stop earning income from working.
Your Financial Independence Income Number is the annual income you would like available to you when you retire or become financially independent. This is the number virtually all retirement calculators use for so-called “expenses” as do the simple retirement formulas like the “25 times” rule of thumb.
Although a fundamental part of developing your FIDough Plan (and accordingly a number you want to get as close to correct as possible) virtually no one explains exactly what you should include and exclude in this critical number means. I have even heard so-called experts discuss this number, and they gloss over (or ignore) some of the key aspects of this number. Yet getting this number wrong, can lead to real trouble down the retirement road.
The following breaks this number down into bite size pieces, and clarifies what you should and should not include when calculating your FIDough Income Number (aka “expenses” in retirement)!
What to include in your FIDough Number
Your usual spending that you expect to continue
Your FIDough Income Number must, of course, cover your usual expenses and spending. If you already track your spending and have done so for several years, that’s a great start. If you do not already track your spending, start doing so now to help guide your FIDough Income Number. (My budget article gives you the basics to get started with tracking your spending and saving, as well as how to increase your savings without any pain).
But only include the spending that you expect to continue after you retire. Many parents currently spend large amounts of money on their children, but presumably (hopefully) that spending will come to an end.
New expected spending, and goal spending
Your FIDough Income Number should also include the spending you can reasonably anticipate. For example, your employer may currently provide health insurance. If you retire early, you will need to plan for that additional spending/expense You should also include anything that your employer currently pays for (e.g., a cell phone) that you will need to cover.
Also include monies for any goal spending. For example, Mrs. FIDough and I plan to travel even more than we currently do, and have in our plan a sizeable travel budget. The key is to recognize that some of your spending will remain the same, and some will be different because of your changed circumstances or because of choices you make. Plan accordingly.
Yuck, I know, it takes all the fun out of it, but planning for taxes is a necessary part of FIDough planning. To account for taxes, you should consider some best and worst case scenarios and make sure you are comfortable with what you might face. So, for example, what would your tax bill look like if you withdrew all of your FIDough in a given year from an IRA subject to ordinary income tax? What if some of the income came from ordinary dividends or long-term capital gains? As explained here, you ideally will have some control over your taxes, but it is better to plan for the worst and hope for the best.
Infrequent big ticket items
Not all spending occurs evenly each year. If you own a home, you will likely need to replace your roof every 20 years or so and your air conditioning/heating units every 7-10 years. If you own one or more cars, you must also plan to replace those on whatever car-replacement schedule fits your values. Include in your FIDough Income Number an amount that will allow you to, in effect, save enough to pay for these infrequent big-ticket items. For example, if you plan to replace a $30,000 car car every 10 years, make sure you build in enough cushion ($3k/year) to permit you to have that extra money after 10years.
Build in some cushion for life’s unexpected events. You want to, of course, anticipate all you reasonably can, but inevitably expenses arise that you never thought would, or some expenses increase more than you expected. So you want to include in your plan some extra amount for unplanned spending. Recognize too, however, in real life you can also adjust spending in other areas if you need to trim.
What to exclude from your FIDough Income Number
Other sources of income
If you expect that other sources of income—pensions, annuities, social security, etc.—will cover some or all of your FI spending, you may exclude these from your FIDough Income Number. In other words, you only need to include in your FIDough Income Number the additional income you need to generate from your assets that is above and beyond the other income you expect in retirement. So, for example, if you can reasonably count on a government pension, exclude that. But do not exclude dividend or interest income because that is income you expect from your FIDough.
Also, if some of these other sources will not keep up with inflation (e.g., the annuity amount will not change over time), build into your FIDough Income Number an amount to, in effect, provide a cost-of-living inflation adjustment to those other income sources that do not already include that benefit. Retirement calculators can also help with that.
Expenses you will no longer incur
If there are work related expenses that you will no longer incur (e.g., dry cleaning, commuting expenses, etc.), you can exclude those from your FIDough Income Number. You may also exclude other expenses you will no longer occur, presumably for example 401K/IRA contributions (although if you retire early you may want to keep contributing to tax advantaged accounts).
Tools to help you calculate your FIDough Income Number
For some of the best tools and calculators to help you determine your FIDough Income Number, check out FIDough’s Favorites.