Contemplating retirement financial needs.

There are unique issues affecting individuals contemplating retirement and trying to determine if they have sufficient assets to do so. For this group, there are at least four financial assumptions that may lead to overestimating eventual financial needs.

Assumption 1: Only Income Can Be Consumed

Most retirement planning revolves around accumulating an asset and having this asset create retirement income used to replace employment income (never invading the principal). Under this assumption, in essence, the principle portion of a retirement account has been earmarked for the benefit of children, or other beneficiaries, or both. However, if a retirement account has been created solely for an individual's personal retirement needs, invasion of the principal is acceptable. For example, if an individual had a retirement account of $1 million with a 10% investment return and a $120,000 annual withdrawal, this asset would last about 20 years. Therefore, assuming that a future retiree can never invade principal will cause retirement needs to be overstated.

Assumption 2: 80% to 100% of Preretirement Income Needed

In planning for retirement, one of the first questions is what percentage of income a future retiree will need in retirement relative to preretirement income. Answers typically range from 80% to in excess of 100%. While this may be true (depending on an individual's goals and plans), as an overall percentage 80%-100% may be unnecessarily high. There are numerous expenditures that occur during the employment years that will not be present in most retirement situations, such as:

* Payment of debt obligations;

* Children expenses;

* Annual savings; and

* Contributing to retirement accounts.

Many people overlook the nonliving cash outlays when comparing current income levels to retirement income needs. Retirees are generally surprised and shocked by how little it takes to live during their retirement years. Future retirees should review their actual cash outlays for current living expenses; this can be a truer reflection of their anticipated needs than starting with today's total gross income and simply applying an applicable estimated percentage.

Assumption 3: A Continuing Increase in Living Expenses

Regardless of age, projections generally assume a continuing escalation of living expenses. This assumption indicates that an 85-year-old person will continue to incur higher living costs than a 75- or 80-year-old. Generally, retirees' activity levels start to decline as they reach 80. To assume that at age 80 (or beyond) a retiree will be as active and continue to incur a high living cost may be unrealistic. One major exception is medical and long-term care costs. These costs could be staggering, and adequate insurance is strongly encouraged to offset the potential expenses. If the future medical and long-term care expenses can be addressed through insurance, most of the other personal expenses will probably remain level (or decrease) due to the inactivity that sets in later in life.

Assumption 4: Income Subject to Social Security Taxes

During employment years (regardless of employment status), most people generally contribute to Social Security based on earned income. For a $100,000 wage earner, Social Security is about 6% of gross income. Income from retirement accounts and investments, however, is not subject to Social Security taxes. Therefore, even if retirement income were to remain equal to employment income, the level of income could be reduced 6%. Most individuals do not factor in the eventual elimination of Social Security taxes on their retirement income.

Conclusion

Many people currently contemplating retirement may have overfunded their retirement needs. As such, these people may have worked longer than they needed to.

FROM TERRY N. NELSON, CPA, PFS, DULUTH, MN