In How Much Money Do You Need to Retire, I mentioned using the 80% rule to calculate retirement needs. You may have heard this rule before; here is a variation of it:
You need 80% of your pre-retirement income during your retirement.
Where Did the 80% Number Come From?
The theory behind the 80% number is that there are things that will cost more during retirement and things that will cost less. Luckily, more things cost less.
What Costs Less
The 80 Percent Rule assumes several things happen by the time you hit retirement
- You would’ve paid off your home mortgage. If not, inflation would’ve made the payments feel much smaller.
- You would be done paying for your children’s expenses.
- You will be in a lower income tax bracket.
- Because you no longer commute to work:
- You will spend less eating out — i.e., breakfasts and lunches.
- You will spend less on transportation.
- You will spend less on clothes and dry cleaning costs.
What Costs More
- You will pay more on home maintenance costs, insurance, and property taxes throughout your retirement.
- You will pay more for car insurance.
- Your utility bills may increase if you stay at home more
- Medical expenses will go up.
Once you take all these factors into account, the assumption is that you will need roughly 80% of your current income to maintain your current lifestyle.
Make The 80 Percent Rule Better
Now, 80% is just a rule of thumb and is not precise. Let’s make some improvements to the rule:
Use Expenses Not Income
Using current income is not a good predictor of your financial needs.
Some people make more than they need. For instance, I doubt Bill Gates needs 80% of his gazillion dollars income to retire comfortably. Conversely, some people spend more than they earn — in fact, a lot of us are in this category.
How much you need for retirement should depend on your expected expenses, not your current income.
Accounting for Taxes
Be sure to include your taxes as part of your expenses.
Unfortunately, income taxes do not disappear when you retire. If your only source of income is Social Security, you’ll most likely avoid income tax altogether. However, if you have other sources of income, e.g., rental income or pension, you’ll have to pay federal, and possibly state income taxes. Withdrawal from traditional IRA and 401(k) are also taxable at your ordinary tax rates.
Depending on your income level and the state you’re in, you are probably looking at around 10-20% effective tax rate. To be conservative, let’s assume 20%.
Based on the two factors above and assuming the 80% holds true, your new rule becomes:
You need 80% of your pre-retirement expenses during your retirement.
For example, if you are currently spending $50,000 a year to live comfortably, you’ll need about $40,000 in income.
The Your Percent Rule
Unfortunately, even the improved version is still very imprecise. The 80% Rule has no idea what your budget looks like and what you plan to do during retirement.
To improve this further, you can figure out a more accurate percentage based on your budget. If you don’t have a budget yet, here is how to start a budget.
For example, let’s say your budget looks something like this:
The green categories will probably go down substantially, and the gray categories could disappear altogether. Let’s assume:
- Mortgage goes down to 5% because you paid off the mortgage and only have to pay property tax, homeowner’s insurance, and HOA fee. (-20%)
- Taxes could go down (let’s assume it go down to 15%) if you earn less or move to a state with a lower income tax. Also, not all of your Social Security income is taxable. (-5%)
- Groceries will probably go down when the kids leave. Let’s assume it go down to 5% (-2%)
- Your contribution for Retirement Savings and Child-Related expenses will most likely go down to 0% (-15% and -12%)
Based on these assumptions, your net expenses go down by 54% (i.e., 20% + 5% + 2% + 15% + 12%) to 48% of your current expenses.
Now, some other categories will probably go up, e.g., medical, travel, activities, etc. Retirees usually want to live out their dreams — e.g., travel to different countries, buy a little cabin in the woods, get a nice car, etc. This means that your post-retirement expenses could be higher in these categories. Let’s assume +25%.
At this point, we are at about 73% of net expenses. The good news is our example already include income taxes. As you can see, it is possible to maintain a decent lifestyle below 80%, assuming you’re debt-free.
The point is, if you have a budget, you can figure out a more accurate percentage of your current expenses you’ll need to cover during retirement.
Accounting for Inflation
One thing that is not covered well is the impact of inflation. All the calculations we have done so far are in today’s dollars. You need to figure out what you need when you’re ready to retire.
Using the Rule of 72 and 3% average inflation rate, your costs of living will double about every 24 years.
To be more precise, you can use an investing calculator (e.g., like this one at Calculator.net). Let’s see how inflation affects a $40,000 income requirement:
- 10 years from now you’d need about $54,000
- 20 years from now you’d need about $72,000
- 30 years from now you’d need about $97,000
Also, most Americans retire around the age of 65 and are expected to live to about 80 years old. That is 15 more years of inflation you will have to account for.
The 80% Rule is a good start to help you think about your retirement income requirement. However, you can do a much better job of figuring out the percentage if you carefully evaluate your budget and decide what you will need, or not need, in the future. And be sure to account for inflation as you do your calculations.
You may need more than 80%, or you may need a lot less, but now you know how much you will need and that is the first step to figuring out how much you need to save so that your retirement savings can produce the right amount income to cover your expenses.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
I’m going to try to live out some of my dreams before retirement (not necessarily the little cabin in the woods ones, but some of the less expensive ones) so that I don’t feel gypped when I get there. Or because I might not get there. My mom will likely make it to 65, but it’s touch and go sometimes. It’s a good thing she didn’t plan to start living then!
I think one of the misleading things about the “80% rule” or “70% rule” is the timing of the “pre-retirement income” – people like us who have young kids and mortgages will not need anywhere near 80% of our current income (adj for inflation) because if you take away the mortgage and kids cost – we don’t spend anywhere near that much now.
All these financial rules come from financial companies so you can pretty much throw them in the garbage in my opinion.
As you note, expenses are the way to calculate retirement needs.
If people do dream of spending time abroad, they may actually need less than they think. The cost of living in most countries is much much lower than in North America even when living similar lifestyles.
I met one retiree recently who spends half the year in South America with his wife. The income they make from renting out their house for those six months more than covers all their living expenses for their time away and provides some savings.
Health insurance is a big cost as one gets older. Many people keeping working later in life to keep their health insurance benefits. At age 66 medicare kicks in.
Investments should focus not just on saving money, but on instruments that keep generating income after one retires.
I view the “80% rule” as dangerous. For the reasons you have given above it will only be the “right” number by sheer chance. It is much better to do your own calculations, allowing for inflation, changes in lifestyle and so on.
@Mrs. Micah – I am sorry about your mom, and like you I intend to live a full and balance live — not too much now and not too much later. @FourPillars – Yeah, they are useful to a degree, but it’s dangerous not to understand how these rules came to be and what factors affect them. I love quick rules of thumb, but always with caution. @Terry – Medicare is one thing I have to learn more about. You’re right on about investing in retirement. Personally, I think some of the standard investment recommendations are too conservative considering 20… Read more »
I think a lot of people forget about inflation when it comes to retirement, it’s great that you included it. This is a good look at a “rule of thumb” and it’s important to understand its reasoning and origins.
80% retirement rule is helpful to work towards as an objective but isn’t always accurate. For example as you appraoch retirement it is likely that some of the major expenditure costs like your mortgage and significant loans will have been paid off and these often take a large chunk of any income. I suppose it depends upon the type of retirement you want.
@Retirehappy – Thank you for your compliment.
@Make Friends – Exactly. That’s why it’s important to understand your financial situation and how the rule comes about.
Well, Sorry but I have to Disagree with this 80% rule.. In both my own and Dozens of others I have consulted thru our Senior Center? It’s more like 110%, not 80% of what their current bills are.. Why so much More? Ans> Human Nature.. 1. Wife wants to go Travel 2. Do more for the Kids and Grandkids 3. Goes Shopping and Has more Lunches with her Fellow retired GF’s & More Dinners with Friends 4. The Man Goes Golfing more with the Guys 5. Buys a New car..his Gold watch if you will 6. They become Winterbirds… 7.… Read more »