Am I Ready To Retire? Consider These 4 Financial Aspects

Posted by Jim Kantowski, CFP®, CPA on April 05, 2022

After several decades of working, it’s only natural to dream of finally vacationing around the world, moving to a cabin or a beach, or just sleeping in every day—whatever it is you envision once you leave the workforce. But how do you know when to retire? The whole process depends on two critical questions:

  • Am I ready to retire?
  • Can I afford to retire?

These two questions are essential because they cover both the mental/emotional and the financial aspects of retirement. People often find the financial side of retirement especially challenging to understand. Keep reading to gain some much-needed clarity about the financial factors of retirement.

Getting Retirement-Ready: A Mental Perspective

This article focuses on the financial aspects of retirement, as that’s what most people are concerned about. However, it’s also important to consider the mental/emotional impact of retiring. Many psychologists agree that beyond your investments and other long-term financial plans, you also need to assess your “psychological portfolio” and ways to “feed your being.

After reading this article, consider learning more about the mental and emotional side of retirement to ensure you can holistically answer the question, Am I ready to retire?

Are you looking for proactive investment guidance that fits into your overall financial plan? Schedule a call with Bay Point Wealth to find out how we can help.

Can I Afford To Retire? 4 Financial Considerations

1. Monthly Spending

How much do you want to spend during retirement? This is a critical baseline consideration. For example, let’s say you currently spend about $10,000 per month and want to continue that lifestyle. This amount covers all your essential needs such as housing, transportation, and food, along with disposable income for activities like shopping, traveling, and other hobbies.

What income sources will make this desired spending level possible? You may have:

  • Social Security income
  • A pension
  • A part-time job

From all these sources, you may receive $4,000 per month, which means you’ll need to make up a $6,000 monthly shortfall. Now the question becomes, How much money do you need to have in investments to supplement your income? (Those investments could be various accounts including 401(k) plans, IRAs, brokerage accounts, and so on.)

One way to answer the question of how much you need is the 4% rule, which is a guideline for the total amount you should withdraw from your retirement savings each year. The 4% rule provides a simple way to estimate whether you’ll have enough money to retire.

Thus, to remedy a $6,000 shortfall in monthly spending using the 4% rule, you would need $6,000 x 12 months ÷ 4% = $1,800,000 in investments.

Keep in mind that the 4% rule is a generally accepted practice for retirees, but it does have some drawbacks—namely, its inflexibility when it comes to lifestyle changes. For example, you may have a sudden increase in monthly expenses due to a spouse’s medical condition or having to care for a grandchild. It fluctuates based on your investment portfolio. If your investments go down, your annual withdrawal would also go down. Plus, the rule doesn’t take into consideration taxes (our next point).

2. Taxes

When people think about retirement, especially if they plan to leave the workforce entirely, they often neglect to consider taxes. While we’re accustomed to paying taxes on work-related income, it’s not always second nature to think about taxes when it comes to income sources like investments.

Returning to our earlier example of $10,000 in monthly spending, all the income sources are taxable, including the retirement plans. This means your calculations will need to include the applicable tax rate for each source based on your overall income.

For example, a portion of Social Security payments (maximum of 85%) are taxed at ordinary income rates. Distributions from pre-tax retirement accounts are taxed at ordinary income rates, but Roth IRA distributions are tax-free. Withdrawals from taxable brokerage accounts will be taxed at capital gains rates (if you sell a stock), which currently range from 0% to 20%. Having a strategic withdrawal plan can help save money and give you a better chance of reaching your goals or passing money on to future generations.

3. Inflation

Whatever amount you have invested won’t maintain its purchasing power as time goes on because of inflation. Even if your spending level stays consistent, inflation—which typically rises at a rate of 3% per year—essentially means a dollar next year won’t buy the same quantity or quality of an item as a dollar today. And the more years you have in retirement, the more likely it is that inflation will eat into your funds.

4. Investment Returns

Recall that we noted how “investments” refers to different types of accounts. It’s important that most of these accounts bear interest, receive dividends, and/or include some other method of increasing in value (such as growth from a stock). You want to be generating returns on your investments that are consistent with the amount needed to reach your goals.

For example: If you need to generate 7% investment returns per year, you may need a portfolio that has a larger share of growth investments (say 60%). Alternatively, if you only need 4% investment returns, you can be more conservative and have less exposure to the riskier growth investments. Creating a portfolio that will help you reach your financial goals and help you sleep at night can be a delicate balancing act.

In most cases, you won’t be working for money during retirement, so it’s critical that your money work for you. Not only should your investments support your anticipated spending habits—they also should earn a sufficient return to cover taxes and inflation. Now you understand several reasons to save early, save often, and invest wisely!

Getting Retirement-Ready: A Big Red Flag

One of the main ways you know you’re not ready to retire is not having a clear picture of your spending. Since you’ll be relying primarily on your investments, you’ll want to get this number right. A small change in spending can have a significant impact on the amount of money you need to last throughout your lifetime.

For example, assume you increase your monthly spending from $10,000 (as discussed above) to $12,000 per month. You’ll now need $2,000 x 12 months ÷ 4% = $600,000 more in investments. In total, that’s $2,400,000 vs. the original $1,800,000.

Getting Retirement-Ready Starts With Strategic Financial Guidance

“Am I ready to retire?” It’s a question we’re often asked at Bay Point Wealth. And we’re always happy to help you figure out how to get to a yes. We take a comprehensive approach to strategizing your investment, tax, and other financial decisions based on your overall financial plans and your unique financial circumstances. We aim to craft a portfolio that can fully support your future.

We’re always refining our investment strategies to help you get the returns you need. Interested in learning more? Schedule a call today.

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Topics: Financial Planning, Retirement Planning