Ready to Retire? Don't Focus on Portfolio Size

Is $2 Million Enough to Retire?

We have all seen the articles questioning if a certain sized portfolio is enough to retire. Whether it is $1 million, $2 million, or $5 million, this is really not the right question to be asking. The ability to retire is not based on portfolio size, it is based on your annual household spending and the amount of income generated from your portfolio. To prevent surprises in retirement it is also important to assess how your retirement funds will be taxed and how inflation reduces the purchasing power of your money over time. To provide an extra cushion in retirement, look for ways to reduce one or two major expenses before you retire. Below we will work through these five factors of annual spending, retirement income generated, inflation, reducing major expenses and income taxability to provide a more accurate picture of retirement readiness rather than solely looking at portfolio size.

Focus on Retirement Income Generated, Minus Living Expenses

Many people think $2 million is more than enough for a successful retirement. But, it all depends on a person's annual expenses and how their portfolio is invested to generate retirement income. If your annual expenses are $70,000 and you have $2 million invested in certificates of deposit earning 1% per year you will severely miss the mark. Your $2 million portfolio is earning a paltry $20,000 per year, missing your $70,000 goal by $50,000. A portfolio that is overly conservative will not earn enough to cover expenses in retirement.

However, if your $2 million is invested in a broad index of 60% stocks and 40% bonds which has earned an average of 9.2% over the last 33 years you would more than cover your annual expenses. With this portfolio mix of stocks and bonds you are following what is called the 4% rule* which means you will withdraw 4% of your total portfolio each year. This strategy allows you to withdraw $80,000 in your first year of retirement with the expectation your portfolio will support similar annual withdrawals for more than 30 years. Your $70,000 in annual expenses are fully covered with approximately $10,000 left over for splurges or reinvesting to supplement your future retirement income.

Inflation and Purchasing Power

The impact of inflation on purchasing power is another reason for focusing on income generated instead of portfolio size. If annual inflation is 2%, an apple that costs $1 today will cost $1.02 next year. Over the years the apple gets increasingly more expensive. As we apply a 2% inflation rate to your $70,000 in household spending it means you will need $71,4000 next year to have the same standard of living. If your portfolio is invested too conservatively it may not generate enough income to cover the cost of inflation. Over time you want to be earning a return that is high enough to cover your household spending needs plus the annual inflation rate. Another benefit of the 4% rule and its 60% stocks and 40% bonds portfolio mix is that it allows for annual increases of 2-3% of your withdrawals to account for inflation.

Lowering Expenses Stretches Your Retirement Income

Another issue with focusing on portfolio size is that it fails to take into account the benefits of eliminating one or two major expenses prior to retirement. For example, if you pay off your mortgage before retiring and eliminate a $2,000 monthly payment, you could reduced your annual living expenses by $15,000. We assume the remaining $9,000 in expenses would consist of property taxes and insurance which are still paid after you pay off a mortgage. If we return to our example above, our expenses are reduced by $15,000, from $70,000 to $55,000 by being mortgage free. Our annual withdrawal of $80,000 using the 4% rule now leaves us with $25,000 for splurges, higher inflation rates in the future, or additional investing. I am a firm believer in focusing on long term happiness in planning for financial freedom and creating an extra $25,000 in annual income will reduce most money related stresses in retirement.

Taxed Income vs. Non Taxed Income

The next factor to consider with retirement income is whether these funds come from taxable accounts (IRA or 401k) or non taxable accounts (Roth IRA or Roth 401k). Mixing withdrawals from these two types of accounts will reduce your annual tax obligations. For example, to cover your $80,000 annual expenses, let's say you withdraw $60,000 from taxable a retirement account (401k) and pay an effective tax rate of 15%. As your income rises you climb into higher tax brackets. Your next $20,000 withdrawal from this taxable account might put you in the 25% tax bracket which would cost $5,000 in taxes.

Instead, you could withdraw the $20,000 from a non taxable account (Roth IRA) which is not taxed. This strategy of mixing your withdrawals between taxable and nontaxable accounts saves you $5,000 in taxes. A good retirement strategy requires drawing retirement income in a way that takes advantage of these opportunities to minimize taxes.

As you prepare to retire, worry less about the size of your portfolio and focus more on the amount of income being generated by your investments, the long term impact of inflation, and strategies for reducing expenses and taxes in retirement.

* The 4% rule posits that you can safely withdraw 4% of your retirement portfolio each year and will have a 95% chance of not running out of money after 33 years. The rule also allows you to increase the amount of your withdraws by 2-3% each year to keep up with inflation. For example if you withdrew $40,000 in your first year of retirement you could withdraw $40,800 in the second year of retirement with the $800 being equal to the 2% increase for inflation.

This article originally appeared on www.loadedforlife.com