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What is Income Replacement?

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By Thomas Anichini, CFA®, CFP®, Chief Investment Strategist

When you save for retirement, you may notice retirement planners use the phrase “income replacement” to help you set your financial retirement goal. Why? What does “income replacement” mean, and why is it so widely regarded as a reasonable goal?

The central problem of funding retirement is: you might work some 40 to 50 years as an adult but based on your savings you will have to support living some 60 to 80 years. How do you fund your living costs over those additional 10 to 40 years? Clearly, you need to save money. But how much? What are you aiming for?

Aim for Maintaining Current Spending

To simplify things, focus on maintaining your current standard of living. How much income, after taxes, would you require to maintain your current living standard? In other words, how much income would you need to replace because you will no longer be working? Hence the term “income replacement.”

Current Spending is Less than Total Income

What you’re spending now is much less than what you make, because you don’t get to keep all you make. Some of it goes to pay Federal income taxes. Depending on where you live, some might also go to state and local income taxes. If you are responsible, you should also be saving for retirement. A good approximation for many is that you are probably able to spend roughly 60% to 65% of your pay.

Figure 1. How Total Income Distills into Spendable Income

Why You Might Need to Spend Less in Retirement Than You Do Now

In retirement you probably won’t drive as much, or spend the same on clothing, or on lunches or coffee out of the house.

If you own a home, you probably also won’t be paying for a mortgage. If you rent, you might rent a smaller place. In total, some or all of these reasons contribute to retirees typically spending less in retirement than they did while working.

Estimating Required Income in Retirement

10 retirees with identical levels of spending might require very different levels of income to afford their spending.

Differences depend on the composition of their wealth (IRAs, Roth IRAs, 401ks), retirement income (Social Security, pensions, annuities), and where they live, because state and local taxes vary widely. If that sounds like too much math, don’t worry! That’s what apps like 3Nickels can do for you.

Planning Apps like 3Nickels Can Help!

3Nickels considers all these aspects and also the following:

Inflation

Investment returns

Federal and state taxes

How Much You Save

Depending on your situation and at what age you wish to retire, 3Nickels tells you how much to save considering all your other financial goals and their priorities. 3Nickels allows you also to plan in case