Retirement income strategies: Income replacement for retirement

One of the biggest questions I hear from people approaching retirement is, “How will I pay my bills?” In this article, I’ll share how you can use Social Security, savings, and other sources to provide the retirement income you need to maintain your lifestyle, plus some strategies I use to create personalized Paycheck Replacement Plans for my financial planning clients at Berkshire Money Management.

Income replacement ratio: how much income will you need in retirement?

How much money you need to sustain your lifestyle and achieve your goals in retirement is different for everyone – no two people have the exact same needs. To find out how big your retirement paycheck should be, there are two places to start: an income replacement ratio or a personalized income replacement plan.

A standard income replacement calculation

Simply put, an income replacement ratio is the percentage of your annual employment income you expect to spend in retirement. Common benchmarks suggest you should aim to generate 80 to 85% of your pre-retirement income in retirement. This ratio assumes you’ll have reduced expenses during retirement, including retirement savings (you won’t be making contributions to your 401(k) anymore), transportation costs, clothing, and other work-related items.

I’m an exact-numbers kind of guy so I hate using “rules of thumb”, but in this case, a rule of thumb can be a helpful place to start if you’re calculating your retirement income on your own.

A personalized income replacement formula

The income replacement ratio can give you a rough starting point, but to feel confident you’re going to reach your retirement goals, you may need something more precise. I work with each of my clients to create a personalized income replacement strategy – their Paycheck Replacement Plan – that serves as a roadmap for reaching their ideal retirement and making their savings last.

The first five years

While the percentage-based income replacement ratio anticipates a reduction in spending, we know from experience that spending often increases during the first five years of retirement. Increased leisure and travel activities that you were unable to enjoy during your working years tend to drive up your average retirement spending in those first several years.

Goal-based planning

A personalized Paycheck Replacement Plan isn’t just about generating income – it’s about generating the income you need to reach your goals. We set specific financial targets based on what you want to achieve, including big events, family vacations, home renovations, charitable giving, and more.

The dynamic nature of retirement expenses

In reality, your post-retirement expenses are never a static percentage of your pre-retirement costs. As you age, healthcare expenses are likely to rise while travel and leisure spending tends to fall. You may face home renovations so you can age in place, or you may downsize to a more manageable space. All of this is not only unique to the individual, but hard to predict 10 or 20 years ahead of time. So, while we try to plan for what’s to come, your retirement income plan will need to adapt as your needs change over time.

Estimating future inflation

When it comes to estimating inflation in retirement, rather than focusing on short-term, possibly atypical rates, we base our predictions on longer-term averages. The current 30-year average for inflation is 2.63%. That may not line up with reality every year (CPI shot up 7% in 2021), but over time, we expect the average to be an accurate predictor of future cost of living increases.

Healthcare inflation in retirement

Not every part of your retirement budget will face inflation at the same rate. Some expenses, like healthcare costs, tend to increase faster than the general inflation index. In 2024, the healthcare inflation rate is estimated to be around 5.43% in contrast to the general average inflation rate of 2.63%. 

Setting goals for retirement

If you ask me, the most important factor in a fulfilling retirement is the ability to meet your goals and live your values. So, when it comes to retirement income strategies, I always begin with a conversation about your aspirations and wishes – not with an income replacement ratio or other numbers talk.

Understanding your individual desires

As you start to think about your retirement income needs, first consider your “why”. 

• What has brought you joy in the past and how can you replicate that feeling in retirement? 
• What are your personal, faith-based, and family values and how do they guide your actions? 
• What hobbies or passions do you want to pursue? 

You may already know the answers to these questions, or you might find that your responses aren’t what you expected. Either way, once you know what drives you, write it down so you can incorporate your goals into your income plan.

Adapting to changes in lifestyle

Your wants and needs 10 years into retirement will likely be different than in year one or year twenty-five. If you have a Paycheck Replacement Plan with BMM, we anticipate changing it over time to meet your evolving needs. 

Whether you work with an advisor or DIY, you’ll want to start planning for some of your future needs right from the start so you can make the most of your wealth. 

• When travel becomes difficult, will you stay home or upgrade to more luxurious options?
• Do you have specific health concerns that will lead to large medical bills?
• Will you move to be closer to family? For better weather? To assisted living?

Setting money aside

What you do with your wealth is a personal choice that’s often tied closely to your individual values. Today, we see more and more seniors who intend to spend all of their savings in retirement, or maybe they plan to leave everything to charity, because they want their heirs to make their own way in the world.

Whether you hope to gift large sums to charity, leave a small fortune to your family, or spend every last cent pursuing your dreams, you’ll want to factor that into your plans for retirement income replacement from the start. 

Understanding your retirement paycheck

Today, most retirees don’t have just one source of income. Beyond knowing your various income streams will support your retirement goals, it’s important to understand and carefully consider the tax implications and regulations surrounding each withdrawal. Careful income planning can help you avoid nasty surprises and make your retirement savings last.

Social Security retirement benefits

If you worked and paid into Social Security during your lifetime, you’re likely eligible to collect a monthly benefit in retirement. Social Security won’t replace your full pre-retirement income – the average is about 40%. If necessary, you can collect Social Security at age 62 but for most Americans, delaying until age 70, or at least until the full retirement age of 67, is preferred to avoid shrinking your benefit.

Pensions and annuities

Traditional pensions, though not as common as in the past, provide steady, reliable income to many retirees – especially those who spent their careers in the public sector.

401(k), 403(b), and traditional IRAs

These common retirement savings accounts provide tax savings during your working years, but in exchange, withdrawals you make in retirement will be subject to income tax (but not Social Security or Medicare taxes). It’s important to pay attention to the regulations surrounding 401(k), 403(b), and IRA accounts as they often have early withdrawal penalties, and later, may face required minimum distributions (RMDs).

Roth IRAs and other post-tax investments

The good news is, withdrawals from Roth IRAs are tax-free, meaning you can draw an income from your Roth investments without driving up your income tax bill or Medicare costs. Roth conversions – when you pay taxes on traditional accounts during low-income years to make future withdrawals tax-free – are a popular strategy to manage long-term tax liabilities.

Business sale proceeds

Individuals who have sold a business may receive income in a lump sum or over the course of several years. If you sold, or are planning to sell, your business to fund your retirement, the way you get paid can significantly impact the rest of your retirement income plan.

Income from rental properties

Owning rental properties can provide a steady and tax-efficient income stream for retirees, though it does come with both risk and responsibility. 

Income from part-time work

Partial retirement and part-time work are popular options for those who wish to supplement their income, create a sense of security, or maintain a sense of purpose while freeing themselves from a full-time career.

Retirement income planning in practice – 3 Examples

I’m a huge nerd about this topic and could talk about formulas and strategies all day. In the interest of keeping things brief, I’ll share a few examples that demonstrate retirement income planning at work.

Example 1. Dave doesn’t do math or distributions (but we do)

Dave just retired with $550,000 saved between his 401(k), IRA, Roth IRA, and Health Savings Account (HSA). His financial plan projected that he needs an income of $6,000 per month to maintain his current lifestyle and meet his goal of spending winters in Puerto Rico. Since he will receive roughly $2,700 from Social Security each month, he needs to draw $3,300 from his other income streams. 

Instead of spending his sunny beach days thinking about how much money he needs next month or which accounts he should pull from, Dave can rest easy knowing it’s already decided and, even better, done for him. His paycheck replacement plan will structure distributions from his taxable 401(k) and IRA, tax-free Roth IRA, and restricted HSA to stretch his savings and generate the income he needs month after month.

Example 2. Jan with the plan

Jan is turning 73 this year, which typically marks the start of required minimum distributions (RMDs) from IRA accounts. Some retirees would be in for an expensive tax surprise. Jan, however, has been preparing for this potential tax bomb for the last 10 years! 

Jan’s retirement income plan laid out a schedule for taking extra income, making Roth conversions, and implementing charitable giving strategies to keep her income – and her tax liability – on target. Because she planned ahead to shrink her IRA, RMDs won’t make an impact on her retirement income – or her taxes.

Example 3. Adventures in early retirement income strategy

Bob and Barb have worked hard for many years to retire at 55 and visit every National Park while they’re still young. They can’t tap into their IRA and 401(k) accounts until they reach 59 ½, so they’ve squirreled away 4 to 5 years of expenses in their non-retirement savings accounts to avoid any early withdrawal penalties. They plan to work during the winter months to supplement those savings. 

Their retirement income strategy outlines how their savings, part-time wages, and future income from Social Security and retirement accounts will come together to cover their expenses each year from 55 to 95 so they can feel confident following their dreams today.

Retirement Income Planning FAQs

1. How do you replace your income in retirement?

Most working Americans will replace at least part of their income in retirement with Social Security. The rest of your “retirement paycheck” will come from savings, investments, and pensions, and sometimes rental income or part-time work.

2. How much of your salary should you replace in retirement?

Generally, you can start by planning to replace roughly 80% of your pre-retirement income in retirement. Your needs, goals, and financial situation are unique to you, so it’s important to take a closer look at your financial picture to decide how much you really need instead of planning around an arbitrary number.

3. How much of my salary will Social Security replace?

On average, Social Security retirement replaces about 40% of a worker’s pre-retirement income, though this percentage varies based on several factors such as income, years worked, and when you begin claiming benefits. The average retired worker received $1905.31 in December 2023, according to the Social Security Administration. You can estimate your own Social Security benefits at SSA.gov.

4. Do I need a financial planner or wealth advisor to replace my income in retirement?

Savvy DIYers can manage their retirement income on their own but should be aware of variables like Social Security ages, required minimum distributions, the tax implications of each income stream, changing laws and regulations, and more.

An experienced financial planner or wealth advisor (like the team at Berkshire Money Management) can help you create a long-term plan for replacing your income in retirement and manage it for you, so you don’t need to spend your retirement worrying about how you’ll get the money to pay your bills.

Are you getting ready to replace your paycheck in retirement?

Keep sight of your goals and important retirement deadlines with this free retirement goal tracker and checklist designed to help you make the most of the five years before retirement!