How to plan for retirement

One of the most significant transitions in life occurs when you retire from work. It brings a lot of freedom, of course, but with that freedom comes some big changes, financial and otherwise.

At the top of the list is that you’ll no longer be able to rely on a paycheck or regular income stream. You’ll be required to generate cash flow from a variety of sources you’ve already established, then make sure that money can meet your needs for 20 to 30 years or longer.

That’s why, before you retire, it’s important to establish a comprehensive retirement income plan that identifies available sources of income and your projected living expenses in retirement.

How to plan for retirement: Five steps to follow

Retirement represents an exciting new stage of life where you can more actively pursue your passions and spend time with family. To fully realize your goals, however, you’ll need to make your financial assets last.

Here are five ways to create a retirement income strategy that both addresses your day-to-day needs and accounts for unknowns like future health care expenses.

1. Assess your retirement income needs for the long run

Your living expenses may evolve over the course of retirement, but for starters, you should try to spell out what your first-year expenses will be. These can be separated into two categories: essential expenses and discretionary costs.

Essential expenses include:

• Housing costs. Estimate your rent or mortgage payments, plus insurance, taxes and ongoing maintenance. Do you plan to retire abroad, move to another part of the country, or downsize locally? Be sure to factor in those decisions when you calculate your costs.
• Day-to-day living expenses. Make sure you’ve allotted for food, clothing, utilities and other needs. Your current costs for each of these categories can provide a useful baseline, although you should adjust based on your expected retirement lifestyle.
• Taxes. Depending on how your retirement accounts are structured, you may need to pay taxes on withdrawals. A portion of your Social Security income may also be subject to tax.
• Healthcare needs. This is typically one of the larger retirement expenses, and Medicare only covers part of it. You should prepare for the possibility of unforeseen health issues that could require out-of-pocket costs.

Discretionary expenses include:

• Travel, entertainment, hobbies or other non-essential expenses that are designed to enhance your quality of life in retirement.
• Any gifts you plan to make to family, such as contributions to a grandchild’s education
• Donations to charities, causes or places of worship.

If you’re a typical retiree, you’ll need roughly 70% to 80% of your current income to fund both essential and discretionary expenses in retirement. Your actual amount may vary after you consider inflation and fluid expenses such as healthcare. That’s why it’s critical to review your income plan on a regular basis to make sure your budget is realistic.

2. Estimate your expected income

After you analyze your retirement expenses, you’ll want to figure out how much income you can expect from guaranteed sources like Social Security, annuities, and pensions, as well as non-guaranteed sources such as investment accounts.

Keep in mind that your various assets may have different tax treatments, which is a critical factor to consider when estimating your future income. Most savings and investment vehicles are placed in one of three tax categories: Fully taxable (sometimes referred to as tax-preferred), tax-deferred (also called tax-advantaged) and tax-free.

• Fully taxable investment accounts. Your savings and traditional brokerage accounts can provide income that may be taxable or, in some cases, are sources of income where taxes have already been paid. Social Security benefits may be subject to taxation depending on your circumstances.
• Tax-deferred investment accounts. Traditional IRAs and 401(k)s, pension plans, deferred compensation payouts and annuities provide income that is subject to current tax.
• Tax-free investment accounts. Income from Roth IRAs and 401(k)s, cash-value life insurance policies, health savings accounts (HSAs) and most municipal bonds are available on a tax-free basis, assuming you meet certain requirements.

Strategically using and withdrawing from accounts in each of these tax categories can be a powerful way to reduce your tax liability and more easily meet your income needs. In general, tax-deferred and tax-free accounts are the preferred vehicles for long-term savings, but finding the right mix depends on your specific financial situation.

For example, when you’re in the early stages of your career, you may want to contribute more to Roth accounts that allow you to make tax-free withdrawals in retirement — a time when you’re likely to be in a higher tax bracket. As you reach your peak-earning years, however, shifting toward traditional retirement accounts may provide a larger overall benefit.

You should also consider having money in taxable accounts. There are no age restrictions as to when you access these assets, so they can be appropriate vehicles for emergency funds and short-term expenses.

3. Position your portfolio for retirement

As you close in on retirement, your investment focus is changing. The emphasis is no longer on accumulating wealth but on generating income over your lifetime.

In most cases, it’s a good idea to gradually increase contributions toward high-quality bonds and other assets with lower volatility. Reducing some of the risk in your portfolio can help mitigate the effects of a potential downturn in the markets early in your retirement, known as downside risk.

However, you’ll still need some exposure to equities and equities-based funds that can generate the growth you’ll need to meet your future income needs. A financial professional can help you build an asset mix tailored to your specific situation.

4. Establish a withdrawal plan and strategy

Retirement represents a major transition: You go from receiving a regular paycheck from your employer to creating your own “paycheck” from your available assets. An effective withdrawal strategy involves identifying available sources of income and using them as efficiently as possible so you don’t risk outliving your money.

One time-tested approach is the retirement bucket strategy, which classifies your income sources based on where you are in retirement. You can customize your income “buckets” according to your situation, although they commonly include:

• Immediate needs (Bucket 1): These funds are reliable income sources that cover the majority of your essential living expenses, like groceries, utilities and mortgage payments. Examples include Social Security, pension payments and required minimum distributions (RMDs) from employer sponsored retirement plans. If you still have any shortfalls in your budget, you may need to make tax-efficient withdrawals from other retirement or investment accounts — or generate income from a part-time job.
• Short-term savings goals (Bucket 2): The second bucket covers expenses you don’t anticipate until roughly years 3 through 10 of retirement. This might include discretionary expenses like an overseas vacation or a home renovation, or unexpected costs such as a major health event. Good sources for short-term savings include certificates of deposit (CDs), money market accounts and short-term fixed-income investments that protect your principal regardless of market conditions.
• Long-term planning (Bucket 3): Beyond the first decade of retirement, you may be thinking about things like long-term care or leaving assets to your loved ones. Since you won’t need to access these funds right away, the money in this bucket should be invested to generate potential growth.

Your income plan should aim to cover at least 80%, and ideally 100%, of your essential expenses using predictable retirement resources (Bucket 1). If you identify a gap in your budget, you may want to consider purchasing an income-producing annuity that can generate a reliable stream of income. Another option is to segregate a specific pool of assets for systematic drawdowns over time.

Remember that taxes are an additional consideration. It’s important to budget for taxes that will be deducted from your income as you plan your retirement income strategy.

5. Reduce expenses in retirement

Even with careful planning, you may find your day-to-day costs in retirement exceed your expectations. Limiting your discretionary expenses can be an effective way to create more room in your budget so you don’t have to worry about making ends meet.

While eliminating small expenditures like cable services and dining out can help, you’ll likely get the most impact by focusing on your largest expense categories. One obvious target is your home. As you get older, you may find that you no longer need the amount of space you once did.

And instead of buying a new car, consider holding onto the one you already own for as long as you can. You might face an occasional maintenance cost, but all least you won’t have to make a substantial loan payment every month.

Reducing your expenses forces you to think about the things that truly give you joy. Sometimes, those are the small pleasures in life, not the ones that create a giant hole in your budget.

Stay financially flexible to maximize your retirement income plan

The most important thing you can do for your retirement is to start planning now. Creating a comprehensive plan — one that accounts for where you are today and where you want to go — will give you milestones to work toward.

In all likelihood, your situation will change throughout your career and into retirement. So, you’ll want to adjust your financial plan along the way to make sure you’re on track.

Meeting with a financial professional at least once a year can help get you closer to your goals. They can review your complete financial picture to make sure you’re saving in a tax-efficient way that provides the right balance between risk and reward. And once you wind down your career, they’ll help you develop a sustainable retirement income strategy so you can live the retirement you’ve always envisioned for yourself.

Frequently asked questions about planning for retirement

What is the 4% rule for retirement?

The 4% rule is a popular retirement withdrawal strategy that’s designed to prevent you from outliving your assets. With this method, you withdraw 4% of your savings in the first year of your retirement, and adjust that amount in subsequent years for inflation.

While this strategy works in most market conditions, it involves certain assumptions. For example, the 4% rule is intended for a 30-year retirement window, so you may need to make adjustments if you retire early. It also assumes that you have a nearly even split of stocks and bonds, giving you a lower chance of success if your portfolio leans on more conservative assets.

How do I account for inflation in retirement planning?

Over time, inflation reduces the value of each dollar you withdraw during retirement. Therefore, you’ll need to increase your withdrawal rate every year to maintain the same purchasing power.

Most withdrawal strategies, including the popular 4% rule, account for inflation already. But during periods of above-average inflation, you may need to make further adjustments to ensure that your withdrawals are sustainable throughout retirement. That may involve reducing expenses or supplementing your income with part-time work.

Though retirees should generally shift toward a more risk-averse asset allocation, you may need some exposure to stocks in order to keep pace with price increases. The unpredictable nature of inflation makes it important to regularly review your investment and withdrawal plan with a financial professional to make sure your assets last.

Where can I calculate my retirement readiness?

A retirement calculator is an easy-to-use tool that gives you a general sense of whether you’re on track. The calculator reveals the probability of meeting your goals based on your current savings, target retirement age and expected expenses in retirement. You can also test different scenarios to see the potential impact on your retirement finances.

How do you see your life in retirement? Realizing your vision starts with a clear plan. Learn how we approach retirement planning.