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3 Ways You're Underestimating Your Retirement Costs

By Kailey Hagen - Apr 23, 2021 at 7:33AM

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Don't wait until you retire to find out you miscalculated how much you need.

When it comes to estimating retirement costs, a lot of people's guesses are way off, sometimes by hundreds of thousands of dollars. That kind of math error is enough to turn retirement from a time of freedom to one of worry and restriction. But that doesn't have to happen to you. 

Below are some of the most common issues that cause people to underestimate their retirement expenses. If any apply to you, follow the tips to fix them now before they come back to bite you in retirement.

Frustrated woman looking at phone screen

Image source: Getty Images.

1. You forgot about inflation

Costs rise over time due to inflation, forcing you to spend more to maintain the same lifestyle you're used to. Inflation rates vary. Since 1980, the annual inflation rate has ranged from 0.1% to 12.5%, but the average annual inflation rate over that time has been about 3%. So that's a good baseline to use when estimating how inflation will affect your costs in retirement.

Start by figuring out how much an average year of retirement would cost based on today's prices. Then, add 3% per year for every subsequent year to get an approximation of how much you'd need to cover your expenses as costs rise. 

For example, if you think you'd need $40,000 to cover your retirement expenses this year, you should save 3% more, or $41,200, to cover the same amount for the next year. For the year after, you'd save 3% more than the $41,200, or $42,436, and so on. If the inflation rate is low one year, you might not spend all that you'd budgeted for. But things should even out if the inflation rate is higher than average in another year.

If you use a retirement calculator, it can factor in the cost of inflation for you. You may be able to enter your own inflation rate, but if that's not an option, check what rate the calculator uses by default. Many already assume a 3% annual inflation rate.

2. You're only saving for 10 to 15 years of retirement

You always want to overestimate the length of your retirement rather than underestimate it. Obviously, there are a lot of factors to consider, including personal and family health history, but if we just look at averages, it's clear retirement could last several decades. 

The average 65-year-old man today can expect to live to slightly beyond 84, while the average 65-year-old woman can expect to live to about 86 1/2, according to the Social Security Administration. That means if you retire at 65, you're looking at about 20 years of retirement. And if you retire earlier or beat these life expectancy averages, you may be looking at 25 years of retirement -- or even 30.

It's always better to plan for a long life and end up leaving extra money to your heirs than it is to run out because you lived longer than you thought. The Social Security Administration has a life expectancy calculator you can use as a starting point, but you should adjust this figure based on your personal health and family history, always figuring a little on the high side to be safe.

3. You forgot about taxes

Unless you use Roth accounts exclusively for retirement, you're still going to owe the government every year once you stop working. How much depends on the tax brackets and the amount you're withdrawing from your retirement accounts each year. 

You can't predict either of those things exactly, but you can get a rough estimate by looking at how much you expect to spend annually in retirement and which tax bracket you believe you'll end up in. The current tax brackets are a good baseline, but remember that as inflation drives up living costs, the income levels for each tax bracket will also adjust accordingly.

What to do if you're underestimating your retirement costs

If you've done any of the three things listed above, you need to make changes before you retire so you don't run out of money. The simplest way to do that is to recalculate how much you need for retirement to include these additional costs. Then, increase your monthly retirement contributions. 

But that's easier said than done for some people. If you can't increase your contributions, you have to look at other ways to fix the problem. Delaying retirement is a solid option that gives you more time to save and decreases how much you need for retirement. You could also consider trimming some of the fat from your retirement budget, although this isn't always possible. Plus, sometimes unexpected costs come up that could force you to spend more than you want to.

A safer option is reducing your expenses today so you can put more money toward your retirement savings. The sooner you begin saving, the easier your job will be because your investments will have longer to grow before you need to cash them out. You could also do a combination of the strategies listed above. Figure out what works best for you and check in with yourself every year to make sure you're on track for your savings goals.

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