Income Replacement Rate in Retirement

How much money do you need in retirement?

When you are working most of your income comes from your job. During retirement your income will come from a variety of sources which may include Social Security, a pension, an annuity, and retirement savings. If you want to keep the same standard of living when you are retired as you did when you were working, you might think that you need to have the same amount of income when you retire. But that is likely not the case. There are a number of expenses that will probably be less or go away entirely when you retire.

Expenses That Lessen in Retirement

Savings for retirement: Whatever percent of your income you put into a 401k, you will no longer need to save when you retire.

Taxes: Since you are no longer working, you will no longer be paying 7.65% of your income in FICA taxes. You also get additional tax breaks when you are 65 or older. If you are bringing in less money, you will likely be in a lower tax bracket.

Employment expenses: Commuting to work requires regular maintenance of your vehicle, such as tires, oil changes, and refueling. Perhaps your family had to have multiple cars which increased those costs. Dressing for retirement activities may be less expensive than dressing for work.

Housing expenses: Retirees who pay off their mortgage near retirement will likely spend much less on housing costs. Some states also offer property tax adjustments for older homeowners.

Expenses That Increase in Retirement

There are some expenses that may increase during retirement. Research indicates that many retirees spend more on some areas than they did when they were working.

Travel is an expense that often increases at least the first few years of retirement. Medical expenses will probably be higher because you will be paying for Medicare Part B, Part D, a Supplemental Plan, dental and vision, and out of pocket costs. The added time you have in retirement often leads to higher entertainment expenses. While many retirees pay off their mortgage before they retire, there may be additional maintenance costs if they are living in an older home. Eventually, roofs wear out, decks need replacement, and heating units don’t last forever.

Rule of Thumb

Financial planners have a rule of thumb that states you should plan on replacing between 70-80% of your preretirement income when you retire. A study by Fidelity found that most people need 55% to 80% of their preretirement income to sustain their lifestyle in retirement. That is a very wide range that makes it difficult to plan.

When we were planning for our retirement, we decided we would look at trying to replace 60% of our preretirement income. We selected that number because we were saving nearly 35% of our income on retirement savings and we had paid off our mortgage several years before we retired.

Our Personal Income Replacement Rate

Our last year that we both worked full time was 2021. We are using what we earned that year as the basis for our preretirement income. Since I retired in the middle of 2022 and Tammie retired at the end of 2022, we don’t count that year. Here is our spending each year of retirement as a percentage of our 2021 preretirement income:

2021: Preretirement Income Base/100%

2023: We spent 50% of our 2021 income.

2024: We spent 47% of our 2021 income.

2025: We are projected to spend 55% of our 2021 income.

Over the last three years our retirement spending has averaged 51% of our 2021 preretirement income.  Most financial planners suggest planning for 70-80% of your preretirement income. How was it possible for us to live on 51% of our preretirement income the last three years?

Here is How We Did It.

What decreased:

We were saving over 25% of our preretirement income on retirement savings. Since we are retired, we no longer have to save for retirement.

We were saving another 10% of our preretirement income in savings accounts in preparation for retirement. This is the money we have been using since we delayed collecting Don’s Social Security until age 70.

Our taxes are now lower (less income taxes because of lower income, not paying FICA taxes, and additional deductions). That equals another 15% of our preretirement income.

The final 10% lower income comes from various savings such as less gasoline from commutes, eating out less, not having to buy work related clothing, and having the time to look for better deals.

What increased:

Travel and entertainment expenses have been much higher during our retirement. Check out our Travel and Activities blog to see all the places we have been and all the activities we have done over the last three years of our retirement. On average we have spent about $14,000 a year on travel and activities during our retirement.

Medical expenses are higher during our retirement. We pay for Medicare Part B, Part D (Prescription), and a Medicare Supplement Plan. In addition, we pay for coverage and out of pocket expenses for dental and vision. Don has had a lot of dental work the last two years. On average we have spent about $12,000 a year on medical expenses over the last three years of our retirement.

What’s the Answer?

What will be your income replacement rate for retirement? The only way to know for sure is to keep really good records. We had budget and income spreadsheets we had used for over 20 years. Based on those records, it was easy to predict about how much of our preretirement income we would need to replace during retirement. Strangely, the higher percentage of your income you are saving for retirement, the lower percentage of your preretirement income you will need to replace.

But if you insist on a rule of thumb, I give you the Jacobs Retirement Income Replacement (JRIR) Calculation:

100 - PIR (Percent of Income you are currently saving for Retirement) - 20 (additional lower costs of retirement) + IRC (Increased Retirement Costs: subjective number between 0-15).

JRIR Calculation: 100 - PIR - 20 + IRC

Using our actual numbers: 100 - 35 - 20 + 10 = 55% replacement rate. Our actual experience has been 51% but that is pretty close.

Here is how I got those numbers: 35 is the percent of our preretirement income we were saving for retirement, 20 is a standard amount that you will not have to spend because you are retired. That includes lower taxes and general costs savings of not having to commute, having more time to look for deals, taking care of more general maintenance around the house, etc. Those two numbers to subtract will give you a pretty good idea of your replacement rate. But the last number, IRC, is a subjective number that indicates there are some areas that you will spend more in retirement. If you prefer to stay home, your hobbies are gardening and reading, and you are in good health that number is likely to be between 0 - 8. If you plan on travelling and taking up new hobbies like golfing, kayaking, and dancing, then that number is likely to be between 9-15. The only number you really have to know for sure to use this calculation is how much you are currently saving for retirement. Try it and see what you come up with.