Make your best guess as to when you will retire. As a small-business owner, you may decide that your retirement plan is to work at your company until you kick the bucket at your desk. But what if something happens along the way, like a health situation or bad business luck, that forces you to retire earlier than planned? The purpose of saving for retirement is to have flexibility. You can always choose to keep working until the end and leave your savings to your children or to charity, but if you can't, then you should be prepared for that, too. Unless you have a specific age in mind, assume a retirement age of 65 if you are over 50 and 67 if you are under 50.
Assume your retirement will have two phases. The amount of money that you need for retirement will mainly be a function of how much you plan to spend once you retire. I suggest splitting this up into two phases: up to age 75 and after age 75. As medical improvements enhance the quality of life, you will have the ability and desire to engage in an active lifestyle even as you age. Today many people in their early seventies travel, throw parties, remodel houses, engage in charitable work and more. Budgeting for retirement as if it were a monolithic stage in life isn't realistic. At some point you will want to slow down and then your expenditures will go down in most areas.
Assume that you will have a long lifespan. Estimating accurately how long you will live can be somewhat of a fool’s errand. Actuaries do a pretty good job, but you don't need to hire one for this exercise. You should assume that you will live at least into your mid-80s. The pace of medical advances increases the lifespan of people in the U.S. by roughly 2 to 3 months every year. So over the next 25 years your life span can be expected to increase by 5 years above the current actuarial estimate for someone like you. There is no harm in overestimating how long you will live; the opposite though can have painful consequences.
Assume that you won't live like a hermit during retirement. Most rules of thumb suggest that you take 80 percent of your current pre-tax income and use that as a benchmark for determining your income needs during retirement. I don't suggest this. During phase one of your retirement you may actually spend more, as your children may need economic assistance, you decide to travel, have an active life, remodel and more. To calculate your retirement income needs in today's dollars you should:
- Estimate your total annual cash expenditures today
- Subtract savings (you won't need to save during retirement)
- Subtract self-employment tax income tax expenditures
Adjust these estimates for inflation. These estimates are in today's dollars. They should be adjusted for inflation assuming an annual rate of 3 percent.
Before you start—be realistic. Before you start working on calculating that figure it’s important to realize that the number will be a moving target. For younger business owners who don't plan to retire for several decades, there are simply too many unknowns that will impact your retirement budget such as the condition of social security and Medicare entitlements, the quality of your health, medical advances that lengthen lifespan, tax policies and more. This exercise should be repeated every few years.
Once you determine your annual expenditures, the next question is: How will you as a small-business owner fund this need? Stay tuned for part two to answer this question.
If you would like a simple Excel-based calculator that can help you prepare an estimate of your retirement needs according to this model, feel free to send me an e-mail at email@example.com and put "retirement calculator" in the subject.