[Pam Krueger is the founder of "WealthRamp" and co-host of "MoneyTrack" on PBS. The national spokesperson for The Institute for the Fiduciary Standard, she is a featured columnist for Investopedia. The views expressed by columnists are those of the author and do not necessarily reflect the views of Investopedia.]

If you believe you're ready to let go of your paycheck and settle into your own definition of retirement, then you probably have some vision of what you want your life to look like after you're done working. But anything and everything you see yourself doing as a retiree – from the basics like staying home and entertaining friends and family to grand visions of traveling the world – also requires a vivid mental image of how much money your new lifestyle will cost.

You may stop working, but the paychecks must keep coming, and now you're the one who decides how much you'll get paid. And it's not as simple as writing yourself a check every week. Your number one job in retirement is making sure your life savings will indeed last the rest of your life. Here are three of the most useful exercises you can lead yourself through – ideally, well before you retire. (If you're already retired, do them anyway!)

#1: Know thyself.

You know the kind of life you want because you’ve probably been day-dreaming about it for years. Now focus in on what that lifestyle will cost. Break it down by imagining how you’ll spend a typical day as a retired person.

This is where you really need to be brutally honest with yourself – and estimate realistically. The Employee Benefit Research Institute found, in a study published in November 2015, that almost half of retired households spend more money during their first two years of retirement than they had spent annually while they were working. In fact, 28% of retired households spend more than 120% of what they spent each year before they retired. It makes sense that you’ll likely splurge a little during the first couple of years because it’s exciting to have so much time on your hands to pursue all sorts of new activities.

After those first two years, many retirees take their foot off the gas pedal and ease up on their spending rate once they realize they can’t sustain the lifestyle. But six years later, one-third of retirees still spend more than they did while they were working, according to the study. It doesn’t seem to matter whether you’re a wealthy retiree or just getting by. The EBRI found that these patterns spanned income levels.

Ideally, you've spent some time contemplating this first question long before you quit your day job. But even if you've already pulled the plug on your career, don’t wait another day to get a rough idea of how much you’re really hoping to spend.

#2: How much can you afford to pay yourself?

Now you know how much you'd like to spend each year, but how much can you afford to spend? A general guideline that’s widely accepted is to consider withdrawing no more than 4% of your nest egg every year. That’s the "safe" rule to ensure you don’t run through your savings too soon. For example, say you have $500,000 saved. It’s a lot of money, but using the 4% rule, you can only pay yourself $20,000 a year from your nest egg without eating into the principal. (And remember, this assumes your investments are earning more than 4% a year.) The 4% drawdown rule has been around since the 1990s when some Trinity University professors wrote about it. Bill Bengen, a financial advisor, was the one who originally came up with the idea. The rule assumes a portfolio split with a 60/40 ratio of stocks/bonds, and it assumes 30 years of retirement, so keep that in mind as well.

According to research from the Bank of America, the average retiree (age 65 and up) has a budget of about $3,700 per month, which means he or she is spending $44,400 a year. But in order to spend that much just from savings, you'll need to have more than $1 million saved if you're following the 4% rule. In general, this rule is a good place to start and then adjust your spending from there, based on the size of your nest egg. 

With interest rates being so low, if you really want to play it safe, 3% may be the new 4%. On that $500,000 pot, that means $15,000, $5,000 less than with a 4% drawdown. Do the math on your savings and see what it would mean for you. Of course you’ll likely have Social Security to supplement your savings, which will add to your available resources. Those lucky enough to also have an actual, old-fashioned defined-benefit pension plan can spend even more.

The X factor any retiree has to consider is rising medical costs. Healthcare is the one spending category that you can’t control, but it usually goes up. Retirees spend, on average, $480 a month for healthcare, compared to $426 per month for those ages 55 to 64, $389 for those ages 45 to 54, and down from there as ages drop, according to the Bank of America research.

 And it could be more. According to National Health Expenditure data cited by the Centers for Medicare and Medicaid Services, healthcare costs for seniors ages 65 and up in 2012, the most recent data cited on a 2017 fact sheet, averaged $1,823 per person per month. Some of that budget is picked up by Medicare, while another piece of the pie is paid by Medicaid, and you will be responsible for some costs out of pocket, as well.

There are wide differences in average monthly healthcare spending due to factors such as age (65 versus 80, for example), an individual's health situation and the state in which a person lives.  A better way to determine how much you should budget is to use a calculator like the one offered by the AARP. Take the results from that calculator and have your advisor check the math to make sure the figures are likely to be a true picture of your situation.

#3: What do I start tapping first?

Where is your "paycheck" coming from? Which accounts should you withdraw from, or should you sell stocks first? This is where knowing a qualified fiduciary financial advisor will pay off because, when it comes to taking money out of your savings, timing is everything. An advisor who specializes in retirement spending can help you make sure you tap the right account at the right time and keep the taxes, fees and expenses on all your investments as low as possible. Knowing which accounts to tap first is key.

For example, Roth IRAs are tax-free to you in retirement because you pay taxes on the funds when you put them in. By contrast, traditional IRAs are taxable in retirement because you did not pay taxes on the funds when you deposited them while you were working. Another question is how large a cash balance you want to keep. Cash can help you pay expenses when the stock market is down and it's not a good time to sell stocks. 

A good advisor will use powerful software to run projections for your spending. In general, advisors suggest that you tap your accounts in this order:

  1. Start with your standard taxable brokerage accounts – This leaves money saved in tax-deferred or tax-free accounts to keep growing while you spend the money you would otherwise have to pay capital gains or dividend taxes on.
  2. Tap into the 401(k) or traditional IRAs – Advisors are generally split on which of these pots you tap first because it depends on the specifics of the accounts and what investments you're able to buy. Generally, traditional IRAs will let you invest wherever you want, but there may be instances where it's better to tap them before your 401(k). A qualified fiduciary advisor will help you here. Due to IRS rules, both of these types of accounts will require you to withdraw at least a certain amount after you're 70½. These are called Required Minimum Distributions and they are one reason some fiduciaries advise you to tap your 401(k) and traditional IRA early so that you can reduce the base on which your RMDs are figured.
  3. Then withdraw from the Roth IRAs – Since you've already paid the taxes on these funds, leave your money in them to grow as long as you can. They don't have any minimum required distributions, so you can wait as long as you want – maybe age 90? 

Remember, as you plan when to tap your savings, that you become eligible to take Social Security when you turn 62. If you don't need to take it that early, you're better off waiting, especially if you're in good health. For every month that you wait, up to age 70, the monthly check you'll get when you file will rise (see Social Security: Saving vs. Delaying Benefits). This is another topic to discuss with your advisor. For example, if you have a spouse who will take spousal benefits instead of his/her own, you may want to start your benefits sooner than 70.

Adding It All Up

Follow these steps to make sure your retirement daydream is as real as possible. This will help you decide when it makes sense to retire and create an action plan (and budget) to make it all work.



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