By Henry K. Hebeler 7-30-05

Several times in the past I’ve shown a very easy way to establish a retirement budget for those who can’t use a computer but can cope with a hand calculator. However, I’ve failed to include examples to help along the way. So let’s revisit the subject.

(1) First, estimate your life expectancy and future tax rate: We’ll illustrate this with an example supposing you are a 70 years old couple with Social Security, a pension or life-time annuity, investments, debts and a house. To get your life-expectancy, you can go to www.livingto100.com. Now suppose you estimated that the longest one of you might live is age 95 which is equivalent to a 25 year life-expectancy. (95 – 70 = 25.) To get an estimate of your future tax rate, you can divide last year’s income taxes by last year’s adjusted gross income, but it’s probably prudent to increase that a little. Let’s suppose your estimated future tax rate is 0.20, or 20%. We’ll use these values as your own in the calculations below.

(2) Social Security: Calculate the after-tax value of your annual Social Security payments. You can spend all of those. Not all of Social Security is taxed, so you’ll have to look at last year’s tax return to find whether 0%, 50%, 85%, or whatever was taxed. If you and your spouse will get $25,000 Social Security this year, and 50% of that is taxed at your tax rate of 20%, then the tax would be 0.20 x 0.50 x $25,000 = $2,500. The after-tax amount you could spend this year from Social Security would then be $25,000 minus $2,500 = $22,500.

Refinement Note: Those who have Part B withheld from their Social Security know that you are already getting less than a full inflation adjustment, and that shortfall is likely to increase for other factors as well. If you felt that Social Security will not keep up with inflation, multiply your Social Security budget by the quantity (1 – 0.4 x life-expectancy x inflation adjustment shortfall). In the example above, if Social Security would lag the actual inflation by 1% or 0.01, then the amount of Social Security you could spend this year would be $22,500 x (1 – 0.4 x 25 x 0.01) = $22,500 x (1 – 0.10) = $19,800. This would leave $22,500 - $19,800 = $2,700 to be reinvested in savings to compensate for inflation later on.

(3) Pension or annuity: If your pension or annuity payments are fully adjusted each year for inflation (few are), use the method above for Social Security. If the payments are fixed for life, multiply the after-tax annual value of your payments times your current age divided by 100. So, if you were getting a $30,000 fixed pension each year, a 20% tax would be 0.20 x $30,000 = $6,000 and the after-tax amount would be $30,000 - $6,000 tax = $24,000. The amount you could afford to spend this year at age 70 would be $24,000 x 70 / 100 = $16,800. That leaves $24,000 - $16,800 = $7,200 to be reinvested to compensate for future inflation.

A Practical Note: Rather than save a certain amount from each Social Security and pension check, it’s usually more practical to spend the entire after-tax amount and reduce the amount that you would otherwise draw from investments by a comparable amount. In this example case the amount you would subtract from the amount you can draw from investments would be $2,700 (if you used the Social Security refinement) as well as $7,200 for a year’s pension withdrawals. Next we’ll calculate how much you project you can afford to draw from investments before such reductions.

(4) Investments: You do not want to run out of money before you die, so the amount you can spend from investments in the coming year is simply the current after-tax value of the balance of investments (less reserves for emergencies) at the end of last year divided by life-expectancy. This theory assumes that deferred-tax investment returns equal inflation, and after-tax returns on taxable accounts also equal inflation. This is likely to be conservative for savvy investors, but could be optimistic for others in adverse situations. Some studies have shown that the average retiree has difficulty keeping up with inflation. Savvy investors will want to use the Investment Refinement Note below to adjust for higher returns.

Now let’s illustrate this with an example. Suppose that at the end of the year, after setting aside some amount for emergency reserves, you have $100,000 in taxable investments and $200,000 in a tax-deferred account such as an IRA.

Taxable (or tax-exempt) accounts: Let's also assume that the taxable investments have $20,000 in untaxed capital gains, that is, the current market value less the original cost. If your capital gains tax rate is 15%, then the current after-tax value of the taxable investments would be $100,000 less $20,000 x 0.15 tax = $97,000.

Deferred-tax accounts: Using the example future tax rate of 20% (not what it might be if you withdrew the entire IRA at one time), the after-tax value of the IRA would be $200,000 less $40,000 tax = $160,000.

So the total after-tax investment value at the end of the last year would be $97,000 from taxable accounts plus $160,000 from deferred-tax accounts = $257,000.

Now, if a conservative estimate of the life-expectancy of the surviving spouse was 25 years, then the amount you could budget to spend for everything except taxes this coming year would be $257,000 / 25 = $10,280. In addition, you could afford to pay whatever taxes were due on the $10,280 draw.

Of course your draws from an IRA are subject to certain rules. If you are under 59 1/2, you would draw from the taxable account only (with some exceptions). If you were over 70 1/2, you would have to withdraw the required minimum distribution. In the latter case, if that IRA draw would give you more than $10,280 after tax, you would reinvest the difference in a taxable account.

Investment Refinement Note: If you expect that you can invest to beat inflation, then you could increase the amount that you can spend by multiplying the amount you calculated above by (1 + real return x life-expectancy / 2). In this example, someone who expects investment returns could beat inflation by 2% or 0.02, i.e., 2% real return, would have an after-tax annual draw to spend from investments of:

$10,280 x (1 + 0.02 x 25 / 2) = $10,280 x (1 + 0.25) = $12,850.

(5) Your total budget: This would be the sum of the three elements above: $22,500 from Social Security, $16,800 from pension, and $10,280 from investments which total $49,580. (If you applied the refinement notes modifying your expectations, the total budget would be $19,800 from Social Security + $16,800 from pension + $12,850 from investments which total $49,450.) This would be the budget for everything except income tax. You would still be able to pay your income tax in addition because we subtracted income tax when we calculated after-tax values.

(6) What if you have debts? It’s always nice to think that people won’t have any debts after retirement, but they often have a mortgage and possibly debts for automobiles or other expenses. One thing you can do is to assume that your budget has to include the debt payments. However, when your debt payments end, you will have a sudden jump in what you can spend for everything besides debt.

If you do not plan to take on additional debt after paying off your existing debts, a more sophisticated way to account for debts and avoid the sudden disposable income change is to divide the debt by your life expectancy and subtract it from your total budget above. So suppose you have a mortgage with a remaining balance of $100,000. Dividing this by your 25 year life expectancy means that you will have to reduce your total annual budget by $4,000, thereby netting $45,580. Even though $4,000 is likely to be less than your actual debt payments, the resulting budget of $45,580 is what you can really afford to spend for everything excluding debt payments and income taxes. So if your actual debt payments were, say $8,000 and your income tax was $12,000, your affordable total cash outlays would be $8,000 debt payments + $12,000 taxes + $45,580 spending = $65,580. This means that you would end the year drawing the following amount from investments: $65,580 – $25,000 gross Social Security –$30,000 gross pension = $10,580 net from investments. This number can vary widely from the after-tax contribution to affordable spending that comes from investments alone depending on the size of debt payments and whether draws are made from taxable or deferred-tax investments. In general, when a choice is possible and allocations are similar, there is a slight advantage to making draws from taxable accounts instead of deferred-tax accounts until very late in life when estate taxes may be a concern.

Some caution is advised if you use the approach above to evaluate the effects of debts even if you don’t plan on taking on additional debt. It is conservative if the after-tax return on your investments is greater than the after-tax interest rate you are paying for the debts. However, if the debt balance is greater than the after-tax value of investments, it is not conservative, and you should use some other method to analyze the effects of debts.

(7) Your home as a source of retirement money. It’s generally not wise to plan on using your home equity as a source of retirement money because you always need some form of housing and a home may be the ultimate source of funds for unseen events late in life. However, if you do plan on downsizing in the near future, you could include the cash you would get from downsizing as a taxable investment in (4) above. If you plan on using a reverse mortgage in the near term, you could include the payments from the reverse mortgage as an annuity in (3) above. Professional financial help would be useful here.

There is no certainty in this or any other projection method. None of us can see the future and know what economic conditions are ahead of us. Investments may behave badly, inflation may be rampant, tax laws can change for the worse, Social Security and pensions may not be paid in full, and unseen events may demand much of our savings. Retirement can be a hazardous venture, so it is wise to plan with caution and avoid being overly optimistic because joining the work force again may be very difficult indeed. You may take some comfort in the fact that similar logic to that used here was used to develop the "required minimum distributions" from IRAs, and presumably the method was well considered before making it law. Still, it may be wise to seek a professional advisor’s help that can go beyond the things we’ve covered here including investments, insurance, estate planning, etc.

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