Connie writes in to ask,
“I’m 58, and I just found out that I’m going to be laid off in less than a month. My previous plan had been to work until 62, then retire and start Social Security right away. Still, it looks like I might have enough money not to have to go back to work if I cut my expenses just a little.
I’ve decided that I’m comfortable with a 4% withdrawal rate. But how do I account for the fact that the amount I’ll need to spend from my investments will decrease in a few years once I start claiming Social Security?”
This type of situation is very common–people whose income will increase at some point during retirement (usually due to Social Security) or whose expenses will decrease at some point (due to a mortgage being paid off or due to qualifying for Medicare, for instance).
In general, the way I’d approach the analysis for such situations is to use some mental accounting. Mentally separate your portfolio into two parts:
- The part that will satisfy your ongoing expenses (using whatever long-term asset allocation and withdrawal rate you choose to use), and
- A lump sum that will be used to pay the additional expenses for the first several years.
So How Much Money Does Connie Need?
So that we can walk through an example, let’s make up a few numbers for Connie. Let’s assume that:
- Her expenses are $35,000 per year (and, aside from inflation, she doesn’t expect that to change),
- She has no pension or other sources of non-investment income, and
- If she claims Social Security at her full retirement age (FRA) of 66, her benefits will amount to $17,000 per year.
Important note: I’m only using this claim-at-FRA scenario for the sake of our first-glance analysis here. It’s not a suggestion that claiming at FRA is necessarily the best approach for early retirees. In some cases it makes sense to take Social Security early, and in other cases it makes sense to delay all the way to age 70.
This means that, for eight years (from age 58 to 66), Connie needs her portfolio to fund $35,000 of expenses. Then, starting at age 66, it will only have to fund $18,000 of expenses ($35,000, minus $17,000 Social Security).
Or, said differently, her portfolio must fund $18,000 of expenses every year for the rest of her life, plus $17,000 of additional expenses for the eight years until she reaches age 66.
Given that Connie is comfortable with a 4% withdrawal rate for the rest of her life, she needs $450,000 ($18,000 ÷ 0.04) to fund the $18,000 of annual expenses.
To that, we add $136,000 (8 x $17,000) for her eight years of higher spending prior to claiming Social Security. (The assumption here is that Connie puts this short-term money in something low-risk like a CD/bond ladder and that it ends up earning a 0% real return.)
So, in total, Connie needs $586,000.
Complicating Factor: Taxes
As you’ve probably noticed, we’ve completely ignored taxes here. Given the numbers we’ve assumed, this isn’t too terrible of an oversimplification.
- At these income levels, Connie’s Social Security benefits would be mostly tax-free,
- At these income levels, long-term capital gains and qualified dividends from taxable accounts would be taxed at 0%,
- Some of her holdings may be in a Roth IRA, which would be entirely tax-free, and
- The first $9,500 ($10,950 once she’s age 65) of otherwise-taxable income would be free from tax due to Connie’s standard deduction and personal exemption.
In other words, given the assumptions we’ve made, Connie’s overall effective tax rate is likely to be less than 5% for most of her retirement. Naturally, your own situation could be quite different–thereby necessitating that you increase the amount of savings needed to fund a given level of retirement spending.