Retirement Planning for Beginners: Part Three

This week Money Mondays is going to last for three days:  Retirement Planning for Beginners in three steps.  I'm pleased to publish a guest post series by reader and frequent comment contributor, D. G. Pratt.  DGP (as he is known in the comments section) retired over a decade ago at the age of 45, so his retirement strategy has been well tested, surviving not one but two nasty bear markets. Monday he covered the basics of creating a budget, yesterday how to figure out how much you'll need, and today, putting that all together.

Where we left off yesterday

But, what if you want to retire early, that is before you reach Social Security age?  For the time, however long you want to make it, between your actual retirement age and your Social Security age (generally about age 66 to 67) you will need to fund your living expenses entirely from your nest egg.  So long as the savings that remain by the time you reach Social Security age are enough to fund your retirement income you will be ok.  Therefore, your nest egg needs to be somewhat larger to pay for the extra years of retirement. 

For example: your retirement budget is $30,000.  Your anticipated Social Security benefit is $10,000 per year.  The difference, $20,000, will need a nest egg of $500,000, as described yesterday.  Suppose your Social Security age is 66 but you want to retire at age 55.  You will need to fund your retirement for 11 years before Social Security kicks in.  You will need additional savings to provide for the $10,000 per year for 11 years.  The simplest way to calculate this is to just multiply $10,000 by 11 for a figure of $110,000.  That number is actually a bit of an overestimate because that money will be generating income until it is spent, but this is a good rough estimate of what you need.  So, $500,000 plus $110,000 equals $610,000.  That is the nest egg you would need to retire at 55 at an income of $30,000 per year, inflation adjusted, for the rest of your life, assuming a 4% real investment return.  [Using a 3% real return you would need $666,000 plus $110,000 for a total of $776,000.]

Step 3: Keeping Score

Now you know how much you need.  How are you doing?  Add up your assets, subtract your liabilities (debts) and you will get your net worth.  Some of that will be your house.  Subtract the cost of a house in the area you expect to be retiring to.  The result is the current size of your nest egg.  Too small?  You have several options.  You can revisit your budget and see if you are willing to live a little more frugally when retired.  But most people will just have to tighten their belts to save more (or get those kids out of the house so that you can really start to save!).  And you can check your mix of investments to see if you can grow the money you already have a bit faster.  At least now you know what target you are aiming for! 

To continue to keep track of your progress I suggest that you revisit your retirement budget every few years and plug in current costs and estimates of what you will need to live, since they will be increasing with inflation.  Then you can generate a new estimate of what your nest egg will need to be.  Your savings and investments should be growing more quickly than the inflated size of the nest egg that you project that you will need.

Good luck!

Thanks to DGP for the great series, Retirement Planning for Beginners!

Related Posts:

    Retirement Planning for Beginners:  Part One

    Retirement Planning for Beginners:  Part Two

    Don't Let Fear Paralyze Your Retirement Plan

 

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Comments

[fred doe]

net worths are weird? since i've retired i've gottin three different net worths for different things, (none for borrowing money) and the difference is about $200,000 some ask for debt some don't? some make you, go" wow i'm worth that" and some make you ask, "is that all". such as long term vs short term investment? i go with the middle one myself.

[deegee]

For someone who retires early (like me, at 45, three years ago), I think there are two phases to planning a long-term budget. The first part is making it intact to age 60 or 65 and the second part is after that. I say this because once I get to age 60 or 65 I will have access to money I could not easily (if at all) access before age 60. These "reinforcements" include unfettered access to my IRA, my frozen company pension, and Social Security. Furthermore, at age 65 (at least for now), I will become eligible for Medicare and greatly decrease my health insurance expenses.

This is also why I have more of my investments in my readily available taxable accounts than I do in my IRA although I have a good amount in the latter.

[Beingretired.wordpress.com]

Nice series! I think it demystifies the question of how much and debunks the idea you need millions and millions to retire. Early retirement is possible for just about anyone with a little discipline.

[dgpcolorado]

@deegee, Your mention of unfettered access to retirement accounts is a valid concern. However, there is a way to tap traditional IRAs before age 59½, without the 10% penalty, which few people know about: by taking payments in the form of an annuity (it used to be called SEPP: Substantially Equal Periodic Payments). I knew of this option before I retired, but the usual method of calculating payments, based on the same life expectancy charts as are used for the age 70 mandatory withdrawals, provided too little money to live on. However, there are two other methods of calculating payments, amortization and annuitization, that can allow for much larger withdrawals. The downside of doing this is that one must follow rules carefully and continue the payments for five years or until age 59½, whichever is longer. Fail to do that and one must pay penalties all the way back to the first early distribution. SEPP using an amortization calculation was my ticket to early retirement. And one can split IRAs up as much as one likes and just tap one, in order to fine tune the amount needed, leaving others in reserve.

Information on early withdrawals from IRAs is found in IRS Publication 590:
http://www.irs.gov/publications/p590/index.html

The relevant passage about taking early withdrawals in the form of an annuity:

"Annuity. You can receive distributions from your traditional IRA that are part of a series of substantially equal payments over your life (or your life expectancy), or over the lives (or the joint life expectancies) of you and your beneficiary, without having to pay the 10% additional tax, even if you receive such distributions before you are age 59½. You must use an IRS-approved distribution method and you must take at least one distribution annually for this exception to apply. The 'required minimum distribution method,' when used for this purpose, results in the exact amount required to be distributed, not the minimum amount.

There are two other IRS-approved distribution methods that you can use. They are generally referred to as the 'fixed amortization method' and the 'fixed annuitization method.' These two methods are not discussed in this publication because they are more complex and generally require professional assistance. For information on these methods, see Revenue Ruling 2002-62, which is on page 710 of Internal Revenue Bulletin 2002-42 at www.irs.gov/pub/irs-irbs/irb02-42.pdf."

I had my amortization calculation done by a local CPA but it turned out that Fidelity Investments, where my IRA accounts are located, will also help with the calculations at no charge. The main variable is deciding on what interest rate to use, it must be reasonable in the eyes of the IRS but still generate the desired income stream.

[deegee]

dgpcolorado, I have seen this mentioned in investment and early
retirement forums. But be assured, having to use this 72t thing is way,
way down on my list of sources of income before I turn 59.5 years old. I
am also a Fidelity client so if I were in such a dire spot where I had to
tap into this, I would seek out their assistance, too.