Your future income need: Defining and prioritizing expenses in retirement

Figuring out how much income you’ll need in retirement is a key step in creating a financial strategy for retirement. You can start by analyzing what you’re likely to spend money on, including health care costs, as well as factoring in the effects of inflation.

For someone getting close to retirement, it's important to figure out how much income you'll need. The answer can help you make appropriate decisions about your savings and investments.

A good way to approach the income question is to think about your likely expenses in retirement. How much will you spend compared to your current expenses? Will your spending change over time?

You may want to start by looking at your current budget. A common rule of thumb is that most retirees spend about 70-80% of what they spent before they retired. But that's just a rule of thumb: you may be able to get a clearer picture by doing an actual budgeting exercise.

That means making lists of your likely expenses. In fact, you may want to make two lists: one for your necessary living expenses and a separate list for the things that you want to spend money on in your retirement years.

Some of your current expenses may decline or even go away entirely. These might include:

• Retirement plan contributions. You’ll no longer be making monthly contributions to 401(k) and IRA accounts.
• FICA taxes. You don’t pay Social Security or Medicare taxes on common types of retirement income, including Social Security benefits and distributions from your retirement accounts.
• Child-rearing and education. If your children are grown, the typical expenses of being a parent may be lower or eliminated altogether.
• Mortgage payments. Many retirees are no longer making home loan payments.

Other expenses may go up, especially health care. Spending on health care also tends to continue increasing as you get further along in retirement. At age 65, the average person spends about 10% of their income on health care, but that goes up to about 20% by age 85.

Health care costs are not the only expenditures that may change over the course of retirement. Spending on travel and recreational activities, for example, tends to be higher in the first years of retirement, then decline as retirees become less active in later years.

For retirees on fixed incomes or with finite resources, inflation is a key factor in financial planning. Simply put, inflation reduces the purchasing power of your money over time. If you're living a happy retirement on $50,000 per year at age 65 and the average annual inflation rate is 2.5%, you'll need about $82,000 per year to enjoy the same lifestyle at age 85.

Another important thing to remember is that the U.S. inflation rate you often see quoted, the Consumer Price Index (CPI), is based on a basket of goods and services that a broad average of Americans buy. The things that retirees spend money on may not necessarily match that average. So if health care costs, for example, are increasing faster than the CPI, the effective rate of inflation for a retiree might also be higher than the CPI.

For many retirees, there can be a kind of spending curve over the course of their retirement. In the more active early years of retirement, your spending may increase even above the rate of inflation. In later years, discretionary spending may decline and partially offset the effects of inflation. Then, in very late retirement, expenses may begin rising faster than inflation again, primarily because of the need to spend more on health care.

In the end, we can all hope to enjoy our retirement. Figuring out your retirement income needs is one key step in creating a financial strategy to help make that dream come true.