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Retirement Funding

by Tim Isbell     Posted 8/2014, revised 2/2015


I wish someone had explained retirement funding to me early in life when I was worrying whether Robin and I were accumulating enough for our senior years. Along the way, we figured it out and now we've been retired since 2010 - and we're doing fine. So it’s time to offer what we've learned to others. If you'd like to understand the sources to fund your retirement and how the numbers work, just keep reading.

A few people start planning for retirement early in their working lives. Many put it off until they purchase a house or get their kids at least partially through college. Some wait even longer. Regardless of where you are in your working life, this post will help you build a retirement plan - or work your way through the retirement you may already be living.

Top view

There is no risk-less way to save enough money to retire.

Even if, from early in our working life, we heroically stash 15% of our income under the mattress every year, it won't be enough. Assuming the Federal Reserve does its job right and history repeats itself, inflation will diminish our stash at about 2.5-3%/year. 

Let's say in our 27th year we earn $40k and stash 15% of it under our mattress ($6k). Further, suppose that our pay increases at the historical rate of inflation (3%/year) for the next 40 years. So each year we increase the number of dollars we stash under the mattress by 3%. This means our Real Return (the return after inflation) is zero. As we get older our bed gets lumpier - but we don't mind.

On our 67th birthday, we decide to retire, so we check to see how much Social Security will provide. It is a nice sum, but it’s not enough to support our then-current lifestyle. So we start pulling dollar bills out from under our mattress to pay the bills. After 40 years of saving 15% of our income each year, we discover a lot of dollar bills, but their buying power has only increased to 40 * $15k/year = $240k. We do the math discover that if we quit our job at age 67, planning to live from Social Security plus $30k/yr flow from our stash, that our stash will be empty in 8 years! But the actuarial tables predict that we'll probably live 25-30 years! So what will we do when our stash runs dry?

The math is clear: we must take some risk through our earning years. Even Olympic savers must invest in things that provide what economists call a "real return." This means a return above the rate of inflation.

So here’s my top-level advice:

  1. Take full advantage of Social Security. We and/or our spouse need to work enough years to qualify fully. Social Security is a splendid deal, and it is an essential component of almost every American's retirement funding.
  2. Save about 15%/year for 30-40 years. This includes the money that accumulates in a tax-advantaged retirement account (including the withdrawals from our paychecks and any company matching).
  3. Invest this savings in ways that produce a real (above inflation) return of 4-7%/yr. We accomplish this a) by wisely investing in various tax-free retirement vehicles (and especially taking full advantage of any employer matching plans), and b) by wisely investing in a taxable investment stash.


Retirement Funding Spreadsheet

For now, just skim this Retirement Funding Spreadsheet - EXAMPLEDon't try to understand everything on the spreadsheet, just get a top-level feel for how it's organized and browse around some of the items. This will provide a framework that will help you understand the topics below. At the bottom of the spreadsheet you can see a link to some Notes. Be sure to check them out.  

How long will I live?

Most professional advice plans for us to live 30 years past retirement, even though most of us won’t. A 67-year-old man today has a 3% chance of living 30 more years, and a 67-year-old woman has a 9% chance. The likelihood that at least one of them lives 30 more years is 12%. So it's not likely that we will live to age 97, but it's possible. And nobody wants to outlive their money. So the usual planning number is 30 years. If we plan for that, most likely we'll leave a nice little nest-egg for our heirs - and we can sleep at night.

Here's a tool to estimate your life expectancy: Life Expectancy Tool (Vanguard).

How much will I spend/year?

Most professionals plan that we'll spend 70-85% of our pre-retirement spending. Maybe these numbers are a bit too conservative. A recent T. Rowe Price survey showed actual numbers of 66%, among people who also said that they were living as well or better than before retirement. If your idea of retirement is cruises, expensive vacations, and lots of fancy restaurants, you will need more than if you like to hike in parks and enjoy sitting at home reading. For planning purposes, a good number to use is 75%.

Where can I get it?

  1. Social Security. Go to for a retirement estimator that provides the monthly benefit you can expect. You need to set up a user id and password because you'll access this site many times over the years. If you are skeptical of the government’s ability to pay the whole benefit when you need it, then discount the Social Security number by 10-20% (a suggestion from William Bernstein’s book Rational Expectations). Depending on our other income sources in retirement, up to 85% of our Social Security check may be taxable as ordinary income. 
  2. Defined-benefit plan. Years ago many employers offered defined-benefit plans. Today these are mostly replaced by self-directed Tax-Free Retirement Accounts (401K, 403B, etc.), often with employers matching your contributions up to some percentage. Payouts from these are usually taxable at ordinary income rates. The exception is a Roth IRA, where you paid the tax many years earlier when you put the money in.
  3. Pay from part-time work. During early retirement, many retirees work part-time. When possible, this helps the retirement math.
  4. Inheritance. While this out of our control (or should be), it sometimes provides a significant source of money. Inheritance taxes depend greatly on how the deceased person set up their estate. For example, if they left us long-term appreciated items, including property, its cost basis "steps up" to the appraised price at the time of death! This is a very generous deal and results in zero tax if we sell the asset immediately. If we hold it a year past the acquisition date, only the increase since we acquired the property gets taxed, and only at the long-term capital gain rate. So inheriting real estate or stock is a very sweet tax deal. However, inherited retirement accounts are different. These get taxed at the ordinary income tax rate of the heir, and these are also subject to Required Minimum Distributions.
  5. Rental income. This can take the form of renting a room for some extra monthly cash or owning rental properties that produce a positive cash flow, or which have capital appreciation they can access as needed. For example, a landlord can sell a property and add the capital gain to their taxable retirement stash. Taxation is the same as before retirement.
  6. Home Equity. Another way homeowners can access money is by downsizing, by selling our house and buying a smaller one more suitable for retirement - and putting the difference in our taxable investment stash. Robin and I did this; you can learn from our experience by checking out Downsizing Basics and also  Home Sale Math. Another approach is to remain in the big house and can also tap home equity is through a “reverse mortgage.” In this case, the homeowner extracts a monthly income stream from the equity in their home. See a tax accountant for taxation on this.
  7. Tax-free retirement stash. Here's a very simple calculator to determine how much you need to invest each month during your working years: Set Your Retirement Goals (Vanguard). First build a tax-free retirement stash in a combination of 401k, 403B, Traditional IRA, or Roth IRA. Each year put as much as possible into these - at least as much as your employer matches. Determine an asset allocation matching your risk tolerance (see Asset Allocation Basics) and invest accordingly. To find out how much you can expect to accumulate in your retirement accounts, check out: Contribution Increase Calculator (Vanguard). This calculator even computes how much of these accounts we can use each month in retirement. Be sure to click on all the links and read all through this tool - there's a lot there! Traditional retirement accounts accumulate tax-free. But when you start withdrawing to fund your retirement days, every dollar gets taxed as ordinary income. Roth retirement accounts are the exception; you purchased these with after-tax money, and in retirement, the payoff is that you can withdraw from these accounts without paying tax. See also "What's an RMD?" section below on this webpage. 
  8. Taxable retirement stash. Many retirees need more money to live than they can get from Social Security and their retirement accounts, which means they need to dip into their taxable investment accounts. They built this stash during their working life and reinvested returns (dividends and capital gains distributions) from their stocks and bonds back into the same investment that generated the distribution. Before starting to sell stock or bond shares to access cash for living, it is smarter to stop reinvesting distributions and divert these into a cash account. For more on this see Mutual Fund Distributions and Taxation, the section on "When to stop reinvesting distributions."
Some readers may wonder why I do not include an annuity in the sources for retirement funding. The reason is two-fold: 
  • Social Security is, by far, the best annuity we can purchase. So before buying an additional commercial annuity, use other money to live so you can delay Social Security until reaching the maximum monthly benefit (currently age 70). See Delay Social Security
  • The money to buy a private annuity comes from our investment stash - so it's just another investment in our stash. And it's not usually a very good one.
Note: If you are a retired minister, be sure to check out Minister's Housing Taxation.

How much should I accumulate?

  • First, estimate how much money you need annually in retirement, say $55k (in today's dollars).
  • Next, estimate how much you will receive from sources 1-6 above. For simplicity, let's assume Social Security will pay you $25k/year, and that sources 2-6 are zero. This leaves a shortfall of $30k/year that you need to fund from investment stashes (sources 7 & 8).
  • Next, apply the Rule of 25, which means multiply this $30k shortfall by 25 to determine the size of investment stashes you need to accumulate by the time you retire so that you have a good statistical chance that it will last through 30 years of retirement. Note that the Rule of 25 assumes you invest in a way that yields a real return (above inflation) of 4%/year. So if you want the stashes to provide $30k/year with a reasonable chance to last 30 years, you need to stash $750k (in today’s dollars). To implement this, you'll need something like an asset allocation that starts out heavy in stocks and by retirement moves to something like 40% stocks and the rest bonds. See William Bernstein's How to tell if your retirement nest egg is big enough article and my  Portfolio Expectations web page for more on this. 
  • To put numbers to the probability that your retirement stashes will last a certain number of years into retirement, check out this calculator: Retirement Nest-Egg Calculator (Vanguard). Be sure to look down to the bottom of that page for an explanation of the assumptions built into the calculator. Using the calculator: if you expect to live 30 years, and you start with a $750k portfolio invested in 80% bonds/20% stocks, and you intend to spend 4% of its initial value in year one and increase this in future years at the rate of inflation, then you have a 91% chance of your money actually lasting 30 years. Experimenting with the number of years shows the probability rising to 100% at 21 years.  

As a point of reference, the average savings rate in the U.S. was 4.5% (April 2014). From 1960 to about 1984 it hovered around 11%, but it has not been above 10% since then. So average Americans are not saving anywhere near enough.

Balance point formula: E = P(R - I)

The above analysis calculates how long a portfolio will last, meaning that our portfolio dropped to zero in 30 years. 

But many retirees want to know what is required for their portfolio to produce the flow of money needed for living expenses while retaining its original value. Not only is this psychologically comforting, it means that the initial retirement stash's buying power remains in the estate, available to heirs and philanthropic causes after you die. So I developed the Balance Point Formula: E = P(R - I) to help retirees see the trade-offs around this balance point.

  • E = annual expenses we need to cover from the money in the portfolio
  • P = total dollars in the portfolio
  • R = gross annual return from the investments in the portfolio
  • I = inflation rate

Note: you can plug any 3 of these variables into the equation and easily find the fourth.

Develop your own spreadsheet

To get started, just download your own copy of this Retirement Funding Spreadsheet - MASTER. Remember that at the bottom of the spreadsheet is a link to Notes that explain key elements of the spreadsheet. Now just start putting in your numbers. The goal, of course, is to figure out a way for the annual expenses to be equal to or less than the annual income that is available.

Kids education or my retirement?

The consensus is clear on this: if we have to make a choice we should prioritize our retirement savings above our kids' college education. Why? Because kids can borrow money for college, but we cannot borrow money for retirement. So unless we expect/want our kids to be our retirement strategy, we need to put retirement savings at the top of the list.

Asset Location Strategies

Investors often talk about asset allocation, but asset location is also an important factor. In other words, some investments are better placed in a tax-free investment account and other investments are better placed in our taxable investment account. For advice on this click on Mutual Fund Distributions and Taxation

What's an RMD?

When we reach 70.5 years old the government requires us to begin annually withdrawing a Required Minimum Distribution (RMD) from our traditional tax-deferred retirement accounts (not Roth IRAs) - whether we need the money or not. Each dollar we withdraw is taxed as ordinary income. For more see RMD Calculator (Vanguard).

Also, note that if you die and leave your traditional retirement accounts to an heir, they will have to pay tax at their income rate. But if you die and leave a taxable account to an heir, they get a stepped up cost basis to the price of the shares as of the date of your death. So it's usually smarter to spend down your retirement accounts faster than your taxable accounts. 

Roth IRAs are different because we paid ordinary income tax on the money before we put it into a Roth. After that, the Roth grew tax-free. In retirement, when we withdraw money from an IRA we pay zero tax - none. Not even on the gains. And a Roth is not subject to the RMD as long as we live. However, if we die and leave our Roth to a beneficiary, then they must take RMDs.

Hope this helps you understand your retirement funding options,


(Edited with Grammarly)

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