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Pretty good advice from Mr. Cruz
Old 08-09-2004, 09:20 AM   #1
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Pretty good advice from Mr. Cruz

Humberto Cruz

Include your taxes in planning retirement
Published August 9, 2004

Q: Recently, you provided "rules of thumb" for required retirement savings. I agree the answer is much more complicated than simple formulas and I personally have a set of spreadsheets to analyze the same question. Nonetheless, it is always good to compare the application of rules of thumb to my results. My question is this: Are the guidelines you discussed before tax or after tax?

A: I intensely dislike (and mistrust) rules of thumb in all financial planning, and particularly retirement planning. But many readers would have my head if I didn't come up with some.

So, I suggested a formula for the amount needed in retirement savings, based on numerous studies of how much money can be safely withdrawn each year from a retirement portfolio.

This formula is based on your "spending shortfall" -- that is, the amount of desired retirement spending not covered by other sources of income such as pensions and Social Security.

My rule of thumb:

If you retire at age 60, multiply your annual spending shortfall by 25. (For example, if you need your savings to produce $30,000 of spendable money the first year of retirement, multiply $30,000 by 25. The answer, $750,000, is how much money you need to be able to spend $30,000 the first year and increase the amount each year to keep up with inflation.

For every year you are over 60 when you retire, subtract 0.5 from 25 and multiply the result by the spending shortfall. (At age 70, you would multiply $30,000 by 20, for $600,000 in savings).

If you are younger than 60 when you retire, add rather than subtract 0.5 for each year. For example, at age 55 you would need $825,000, or 27.5 times $30,000.

I should have anticipated the question of whether the spending shortfall was before or after taxes. The question always comes up whenever I discuss projected expenditures or savings goals.

And yet, the issue never occurs to me because I look at taxes as I would any other expenditure, such as health care, the groceries or the electric bill. (Whenever I discuss savings goals or spending projections, they will be before taxes.)

Although this view is far from being universally shared, I would suggest it is the only proper way to plan your finances. Taxes are just another expense, to be budgeted and managed wisely. Being aware of this expense is the first step to reduce it.

Besides, not everybody's tax situation is the same, so how can you generalize? A retiree who gets his income from qualified stock dividends, which are taxed at a maximum rate of 15 percent, will pay less in taxes than one who gets his income from taxable interest, which can be taxed as high as 35 percent. A retiree who simply draws down previously taxed principal for living expenses incurs no tax obligation.

As for my wife, Georgina, and me, quarterly estimated tax payments have been our biggest expense the past two years because they must include not only federal income tax but also self-employed Social Security and Medicare tax on our freelance writing earnings.

Bottom line: Be aware of what you pay in taxes, and include it in your expense projection.

Part-Owner of Texas

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Re: Pretty good advice from Mr. Cruz
Old 08-09-2004, 09:23 AM   #2
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Re: Pretty good advice from Mr. Cruz

And I love "rules of thumb". Why? Because they are
easy. I'm way too lazy to crunch all those numbers.
So far so good..................

John Galt
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Re: Pretty good advice from Mr. Cruz
Old 08-09-2004, 11:57 AM   #3
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Re: Pretty good advice from Mr. Cruz

Seems like good advice on the tax question. As a "rule of thumb" it seems utterly useless since for most of us the "shortfall" changes as SS, medicare, pensions etc. kick in along the way...
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Re: Pretty good advice from Mr. Cruz
Old 08-09-2004, 02:38 PM   #4
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Re: Pretty good advice from Mr. Cruz

I "assume" that these type of formulas exclude the income from from SS and of course pensions.

For example if my expense will be $40K at 57, according to the formula, I will need $1060K.

If you receive $20K 5 years later from SS, how will that alter the initial amount of $1060K.

Assuming you live a very long life, how does life expectancy effect this formula?

I look to the present moment because that's where I live my life.
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Re: Pretty good advice from Mr. Cruz
Old 08-09-2004, 06:00 PM   #5
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Re: Pretty good advice from Mr. Cruz

If you follow his rule of thumb, he starts out with a 4% SWR for someone 60 years old, (1/25) but that falls to a 3.07% SWR (1/32.5) for a 45 year old. Interesting. (assuming we still believe in SWRs around here!)

ER for 10 years; living off 4.3% of savings (and a few book royalties ;-)
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