Retirement is the end-goal for many people. Yet, it is important to understand the basic level of income needed to sustain you in retirement. That is where the retirement replacement ratio comes in. But what is a retirement replacement ratio?
A person’s retirement replacement ratio is their gross income after retirement divided by their gross income before retirement.
For example, if a couple makes about $60,000 a year before retirement, their spendable income would be about $45,000-$47,000. Taxes and savings account for over 18 percent of that income.
The couple would only need around $45,000 in retirement to sustain their standard of living. Their replacement ratio is around 75 percent if we divide the $45,000 with $60,000. The couple will need 75 percent of their preretirement income to maintain their lifestyle in retirement.
It is generally accepted that your replacement ratio should be around 75 percent.
It is also important to keep in mind that people need less income after retiring. In retirement, income taxes decrease. Social Security taxes also end and saving for retirement is no longer necessary. That means your gross and net income are close in numbers during retirement.
With that said, it also important to consider your personal finances. Most experts assume those in retirement no longer have dependents or mortgages. That may not be the case for everyone. So, let’s go over ways you can plan for retirement. We want to help you determine what income you will need to maintain your lifestyle.
What Percentage of Current Income is Needed for Retirement?
Planning for retirement is stressful, and that is understandable. How do you even know what income you need to maintain in retirement? Believe it or not, the answer is in your retirement replacement ratio.
Many experts say that a 70-75 percent replacement ratio is the standard amount.
To get an idea of your ratio, take a look at your gross income, meaning the income before taxes. Then look at your net income–the rest of your income after taxes and other expenses. This will give you a rough estimate of how much income you will need in retirement.
If we use the example of the couple from above, their net income is around $45,000-$47,000 a year. In retirement, they will need around $45,000 a year to sustain their standard of living. (Helpful Tip: Keep in mind that expenses tend to decrease in retirement).
In this scenario, their replacement ratio is about 75 percent. Remember, we found that number by dividing $45,000 with $60,000. This couple will need 75 percent of their income to sustain in retirement.
To find your percentage, you can divide your gross income with your net income. From there, you will get your income percentage needed in retirement.
Setting the Foundation of Your Plan
It is important to discuss how to plan for that desired ratio in retirement. If we keep using the couple as an example, they will need 75 percent of their $60,000 income. They will need to plan how to achieve that ratio once they have retired.
Luckily, we live in a digital age where computer software programs, online calculators and worksheets are at our disposal. You can use your ratio to estimate how much you need to save to cover any deficits from retirement earnings. Your earnings will come from Social Security, pension, investments and retirement employment.
If your retirement earnings fall short of your ratio, there are solutions. You can increase your savings rate. Some people even move to a lower-cost location when they have retired. Downsizing is a great way to maintain your replacement ratio.
It is important to set a foundation for your retirement plans. Luckily, the retirement replacement ratio makes it easy to do that.
What Retirement Income Replacement Ratio Studies Tell Us
Many experts’ opinions vary on the amount of income needed in retirement. The general agreement is that retirees need less money because their expenses are lower.
Studies have found that replacement ratios may differ depending on income levels. Lower-income and higher-income households are likely to need higher ratios than middle-income.
With a preretirement income of $20,000, replacements ratio moved up to 89 percent. As income increased, the ratio declined to 75 percent for those making $60,000. Then replacement ratios increased once again to 88 percent for high-income households.
Taking this into consideration, the average replacement ratio should be around 70 percent.
In retirement, you will not need 100 percent of your pre retirement income. Remember, expenses and taxes will decrease once you have retired. Social Security taxes are no longer necessary. Federal income taxes are also lower.
Retirement planning can be tedious, but it will be worth the work. Retirement replacement ratios are available to help you plan for that retired future. After you have figured out what income percentage you need, it will be that much easier to plan for your retired life.
Don’t forget to use your ratio when planning. Keep in mind that ballpark figures are great for planning distant retirements. When the retirement is nearing, you will make more accurate calculations. In the end, those calculations will help you make the most of your retirement.