The last five years before you retire may be a critical point of time—at least when it comes to retirement planning. That's because you must determine whether you truly can afford to quit work within that period of time. The determination will hinge heavily on the amount of preparation you have done to date and the results of that preparation.
If you are financially prepared, you may just need to maintain your program and continue on to your retirement goal. If you are not prepared, you may be looking at more than five years—or a modification of your planned retirement lifestyle.
Let's look at an action plan you can use to determine your level of readiness as you start the five-year stretch.
- If you hope to retire in five years, now's a good time to do a realistic retirement needs analysis.
- Estimate how much you plan to spend each year by using your current budget.
- Compare your planned expenses to how much retirement income you can reasonably expect.
- Estimate your life expectancy and insure your assets against long illnesses.
- If your expenses are too high or your income is too low, you may have to make some changes or adjust your retirement schedule.
Failing to do a proper retirement needs analysis is one reason many people find themselves struggling financially during their post-work life. At its most basic level, an analysis of your retirement needs might consist of multiplying your current income by some recommended percentage, such as 75% or 80%. That's based on the assumption that your expenses are likely to go down after you retire, which unfortunately is often not the case.
To get a more realistic picture of how much money you'll need for retirement, your analysis should take a holistic approach. This means considering all aspects of your finances, including items that could affect your cash flow and expenditures.
Below are some questions to ask yourself.
With half a decade left until your planned retirement date, the key objective is to determine if you can afford to retire by then. To make this determination, you must first consider how long you expect to live.
Unless you are clairvoyant, there is no way to be sure. However, you can make a reasonable estimate based on your general level of health and family history. For example, if your family members typically live into their 80s and you are in good health, then you may want to assume that you'll still be around at that age.
While you're pondering life expectancy, also consider whether your family has been prone to costly, long-term illnesses. If so, insuring your retirement assets should be high on the list of items to include in your analysis. You may want to consider long-term care (LTC) insurance to pay for nursing home care or similar services should you eventually need them.
Having to use your retirement savings to pay expenses could wipe out your nest egg in no time. This is especially true if your assets are significant enough that it's unlikely you will qualify for Medicaid-supported nursing home care—but you're not so wealthy that your assets will easily cover whatever happens to you. If you're married, consider what would happen if one partner became sick and drained the savings intended to support the other partner after a spouse's death.
Projecting your expenses during retirement can be one of the easier parts of your needs analysis. This is as simple as making a list of the items or experiences you expect to spend money on and determining how much they are likely to cost.
One way is to use your current budget as the starting point. Then eliminate or lower the expenses that will no longer apply, such as the gasoline you use to commute to and from work, and add or increase the items that will represent new expenses during retirement (such as higher home utility bills or more leisure travel).
When you tally up your financial resources, don't forget any property that might produce income or that you could sell and convert into cash, such as real estate.
Next, add up the income you are guaranteed to receive in retirement. This includes:
- Your monthly Social Security benefits. You can get an estimate of your Social Security benefits by using a calculator at the Social Security Administration (SSA) website.
- Any pension income from current or former employers.
- Any funds coming as regular payments from an annuity you own.
- Any property, real or intellectual, that you plan to sell or collect ongoing payments from to help finance your retirement, including real estate royalties, or rental properties.
- Once you reach the age of being subject to required minimum distributions (RMDs) get an estimate of how much you will be required to take out and add this to your guaranteed income for that period.1
Also, inventory any other savings and assets you have that you could draw on in retirement:
- Funds you have saved in retirement savings accounts, such as IRAs and 401(k)s.
- Inherited IRAs and other inherited retirement accounts. Be aware that distribution rules for inherited retirement accounts changed with the Setiing every Community up for Retirement Enhancement (SECURE). Before the passage of this Act, certain non-spouse beneficiaries could spread the disbursements of their inherited money over their lifetime. With the SECURE Act, these beneficiaries have 10 years from the death of the retirement account owner to take full distributions.2
- Money in other savings or investment accounts.
- Your Health Savings Account (HSA), if you have one.
- The value of your home or other real estate property.
- Any other valuable property, such as art.
The age to take RMDs was increased to 73 with the passing of the SECURE Act 2.0. If you turned that age on or after Jan. 1, 2023, you must begin taking distributions from your qualified retirement account(s) by April 1 of the following year. Prior to this, the age to take RMDs was 72 if account holders turned that age between Jan. 1, 2020, and Dec. 31, 2022.3
Once you have established your projected expenses and the amount of income you will regularly receive, the next step is to determine how much additional money you'll need to draw from the retirement savings and other assets you just inventoried to support yourself.
Below is an example of that calculation, based on the following assumptions:
- This person plans to retire in five years.
- Their annual retirement expenses will be 75% of their pre-retirement income.
- They expect to spend 20 years in retirement.
- Their current annual income is $250,000, and they will receive an estimated salary increase of 5% per year.
- Their estimated income from Social security is $24,528 per year.
- Their current retirement savings balance is $1.5 million, which they project will grow at a rate of 8% per year.
In this case, the results look like this:
Image by Sabrina Jiang © Investopedia 2021
You can get a calculator for this calculation at http://www.choosetosave.org/.
Even though our hypothetical pre-retiree has a higher-than-average income and retirement savings, the calculation shows that they are on track to replace only about 64% of their pre-retirement income, a good deal less than the 75% replacement rate they were aiming for. That means they'll have to make some adjustments if they want to retire in five years.
Your particular facts and circumstances will likely produce different results. For instance, do you have more or less saved? Will you get more or less from Social Security? Will your income from other sources be higher or lower? Is your projected time in retirement longer or shorter? All of these factors could change the bottom line.
If the result of your retirement-needs analysis shows that you are on track, congratulations! You'll still want to keep adding the recommended amounts—more if possible—to your savings and rebalacing your portfolio as necessary so that it's suitable for your retirement horizon.
If the results of your needs analysis show that you are not financially prepared to retire in five years, here are some things to consider:
- Could you make some changes to your planned retirement lifestyle that would significantly reduce your annual expenses?
- Would you be able to increase your retirement account contributions enough over the next five years so that they'll produce sufficient income once you retire?
- Could you work part-time in retirement and bring in additional income?
If there isn't much you can do to reduce your expenses or increase your income, your best option may be to put retirement off for a few more years. The longer you work, the more time you'll have to set money aside, and the fewer years you'll need to rely on your retirement savings to support yourself.
The amount of money you'll need during retirement depends on a number of factors. The general rule is that you should save up enough money to maintain your current lifestyle. Some experts believe this figure falls somewhere in the neighborhood between 70% to 80% of your current income.4 Keep in mind that some individuals may use more while others can use less than that. The best way to determine how much money you'll need is to try to estimate your costs, including housing, food, healthcare, travel, liabilities, and other expenses.
It's always a good idea to review your retirement plan and accounts on a regular basis. That's because your situation may change over time, including your income, personal situation, and family life among other things. And keep in mind that, as you age, your risk tolerance decreases, so the older you get, you'll want more stable investments that may not be as volatile as those you invested in when you were younger. But the last five years before you intend to retire may be the most important as this is the point in your life when you can truly determine whether you can actually leave the workforce as you planned. If that isn't the case, you'll have to make some changes and adjust your retirement date.
It's always a good idea to review your retirement accounts and plan on a consistent basis. But the last five years before your intended retirement date may be the most important. That's because things can change, whether that's your job, family situation, or your own goals. At this point, you'll know whether you're on track and if retiring is still an option. Be prepared, though. If the stars don't align, you may need to make changes and alter your date. You may also need to make some other adjustments, like rebalancing your portfolio.
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