How much you'll need in retirement

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

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NEW YORK (Money) -- Question: I always heard that you will need 80% or so of your working salary to live on in retirement. But is that a percentage of your gross income or your take-home pay? --Mary Taylor, Chalfont, Pennsylvania

Answer: This rule of thumb has long confused many people who are trying to get a handle on their retirement planning. But the question of how much income you'll need to live comfortably after calling it a career has taken on a special urgency the last year or so as retirement account balances wilted during the market's meltdown.

After all, if you earn roughly $100,000 a year and take home, say, $80,000 after taxes, the difference between requiring 80% of your gross income ($80,000) and 80% of your net income after taxes ($64,000) is substantial. Unless you've got a pretty sizeable nest egg, the difference between coming up with $80,000 a year (plus inflation increases to maintain purchasing power) and $64,000 can have a significant impact on whether your money can support you the rest of your life.

So now is a good time to re-examine this oft quoted benchmark and add a bit of perspective about how to apply this rule to your retirement planning.

Before I get to your specific question, though, a quick word about where this rule of thumb comes from. The percentage stems from the "replacement ratio" studies that Aon Consulting and Georgia State University have done for the last 20 years. Basically, researchers cull information from the Bureau of Labor Statistics' Consumer Expenditures Survey, which details how U.S. consumers, including older households, spend their money.

By using this and other data and making some reasonable assumptions, the study authors calculate the percentage of pre-retirement salary retirees need on average to maintain their standard of living once they retire.

Before or after taxes?

The replacement ratios compiled in the study refer to gross income, or income before taxes. So, for example, if your pre-tax income prior to retirement is, say, $50,000, an 80% replacement ratio would mean that you would need $40,000 of income before taxes in retirement to live roughly the same lifestyle.

There are several reasons the amount of gross income you need after you retire falls. One is that most people pay less in taxes after retiring. Generally, your income falls in retirement, which means your income tax bill declines. The fact that extra deductions are sometimes available for people over 65 and that you no longer have to pay Social Security payroll taxes after you stop working also accounts for a lower post-retirement tax burden.

The other big factor in reducing the amount of income you need is that you no longer have to save for retirement once you've retired. So the portion of income that you plowed into 401(k)s and other retirement accounts during your career is now available for living expenses.

Speaking of living expenses, they come into the picture too, although they can cut both ways. Some are likely to fall in retirement (no more commuting and other work-related expenses), while others tend to go up (higher health care costs and, given more free time, more spending on entertainment). But when you total all the changes -- and you can see how that's done by looking at Appendix III in the 2008 version of the Replacement Ratio study -- the result is that most people need less pre-tax income in retirement to keep a similar standard of living.

One size doesn't fit all

If you glance through the study, you'll notice that the 80% replacement figure doesn't apply to everyone. That's because what you'll need tends to go up as your income rises, in large part because taxes don't go down as much. So, for example, while the study shows an 80% replacement rate for people with incomes of $50,000 prior to retiring, the percentage jumps to 88% for pre-retirement incomes of $250,000. The percentage also varies depending on whether you're single or married.

Even if you find the replacement ratio for someone with a similar income and type of household, you can't assume that the same percentage makes sense for you. The percentages in the study are averages based on thousands of people. You, on the other hand, are one person. Your expenses and sources of income are likely to differ somewhat from the average, which will affect how much income you'll need in retirement.

For example, all else equal, someone going into retirement without a mortgage will require a lower percentage of pre-retirement income than someone who refinanced late in his career and has a sizeable loan balance. Conversely, if you envision retirement as a time to travel the world, you'll likely need more income than someone whose ideal retirement is puttering around in his garden.

Give yourself a cushion

It's okay to use these estimates as a ballpark figure to plug into calculators like our Retirement Planner, but assuming you want to be sure you have enough to retire comfortably, I think you ought to take a conservative stance. For example, if the average for someone with your income is, say, 80%, I'd probably shoot for replacing 85% to 90% of pre-retirement income.

Granted, you may end up saving a bit more than you need to and foregoing some pleasures today. But I'd rather err on the side of having a nest egg that's too large than too small.

Once you get closer to your planned retirement -- say, within 5 or 10 years -- I think you want to get a better idea of what your actual retirement spending may be rather than relying on a rule of thumb. To do that, you can go to an online calculator like Fidelity's Retirement Income Planner, which helps you divide your spending into dozens of categories.

So if you want to know more about the so-called 80% rule, I suggest you check out the 2008 replacement ratio study (which also has lots of other material that can help with your retirement planning.) But whatever replacement rate seems right for your situation, kick it up a notch or two to give yourself a cushion.