Recently, an article appeared in Marketwatch touting “Four Gorgeous Beach Towns Where You Can Retire Comfortably on $40,000 A Year.”
While the thought of retiring to a beach certainly is appealing, this article wasn’t unique in its approach. If you start an internet search with the question “Where Can I Retire,” you’ll see results like:
- “Where Can I Retire With $300K?”
- “Where Can I Retire Cheaply?
- “Where Can I Retire With $50K?”
- “Where Can I Retire For $500 A Month?”
Beachfront living aside, these searches and articles raise a major question for current workers and savers:
Do you know how much you’ll need each year in retirement? And for that matter, do you know how much your lifestyle is costing you now?
Uncovering The True Cost Of Your Expenses
You might keep a budget. You might track your expenses. If so, you deserve a pat on the back for showing some serious financial discipline.
But your lifestyle still might cost you more than you realize. And that could lead to a surprise when you try to figure out how much you’ll need once you stop working.
It’s not because your budget is misguided or your tracking tools are lousy. It’s because of an underappreciated personal finance reality that is so commonplace we often forget it:
We make most purchases with after-tax money.
Think about it for a moment. While you might have access to a qualified retirement plan at work, any remaining income gets taxed immediately by Uncle Sam. As a result, you're only able to buy the things you need and want after you pay your tax bill.
It doesn’t matter if you’re putting gas in your car, buying groceries for your family, or paying the cable bill. The taxman takes his cut first.
The reality is that for every dollar you spend, you need to make more than a dollar to cover it. How much more depends on your tax bracket. If you’re in the 30% tax bracket (federal and state combined), you’ll need to make $2.86 to cover a $2 cup of coffee. Only after their $2.86 gets taxed by 30% will you have the $2 you need to pay for your morning caffeine.
The same holds true for larger purchases. You’ll need to make $18.55 for a $12.99 Netflix subscription, $71.40 for a $50 birthday present for your kids, and $42,840 for a $30,000 new car.
Even worse, you pay for Social Security on an after-tax basis. That means you need to make extra money just to cover the cost of having Social Security deducted from your paycheck.
Put it all together and you might finally have an answer to the question “where does all the money go?” A lot of it goes to the “grossed up” costs of covering your expenses.
How Much Extra Are We Talking Here?
You need two things in order to figure out how much extra your expenses are really costing you.
The first is your combined state and federal tax rate, which you can get with a Google search and some fairly simple addition. Here’s a federal tax table for 2019:
And here is a look at state tax rates:
Add those two together, and you’ll have an estimate of the taxes you pay.
The second thing you need is a multiple based on your tax rate. Here’s a table we use with our clients.
Once you have these, you just need to multiply the sticker price of any expense with your top tax rate multiple. Let’s say you make $100K a year and you live in Virginia. You can estimate a 29.75% tax rate (24% federal and 5.75% state). Round it up to 30% to make it easy, and you’ll see that your tax multiple is .428. Then just multiply the sticker price of your expense by that multiple. That’s how your $70 dinner date ends up costing you $99.96 ($70 x 1.432) in earnings.
Nice Trick…But So What?
As part of our financial process, we like to “gross up” our clients’ expenses to help them understand how much money they need to cover their lifestyle. We don’t make any judgments – what they spend their money on is their business - but we want people to understand the true costs of their spending decisions.
Once we understand how much a client’s lifestyle costs, we can compare that with any expected retirement income (from social security, pensions, etc.). That allows us to estimate how much income they’ll need to pull from their portfolios each year in retirement.
On a behavioral level, we hope this additional knowledge can help fight lifestyle creep: a phenomenon that occurs when someone’s standard of living rises along with increases income. Lifestyle creep can be dangerous because it often...well...creeps up on us without us knowing.
Consider a man who makes $80K a year and gets a promotion and salary increase. Now our man is making closer to $90K. He might think he has some extra breathing room and can afford to spend $10K more.
He’d be sorely mistaken.
One way to avoid lifestyle creep is to direct any increase in income into savings. If you can do it in a tax-deferred vehicle, then it’s even better.
The Bottom Line
We’re not here to tell you to spend less money. Our job, instead, is to educate you and to help you make decisions with your eyes fully open. Knowing the “true cost” of your spending can be an important tool as you make your way towards financial independence.
Next time you have a few minutes, run some spending calculations. You might be surprised to find out how much you’ll actually need when you stop working. That beachfront retirement could be further...or closer...than you previously thought.