Why You Can't Trust Those Retirement Calculators

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By Jon Stein, founder and CEO of Betterment

There are a lot of basic retirement calculators on the Internet, but few of them take into consideration the factors that are truly important.

It's not your current income that's the key piece of information to determine your retirement number -- it's how much you want and need to spend during retirement.

What you'll spend in the future depends on where you live, your typical spending patterns and the tax and growth profiles of your investments.

The reason so many retirement calculators fall short is that making these kinds of calculations in relationship to one another is complicated, and so far, few calculators offer all of these inputs under one roof with a robust algorithm and an easy-to-use interface.

But we're getting there. Today we have the right data that can get you closer to the actual savings you'll need for retirement, based on the lifestyle you plan on having. That means there is a smaller and smaller margin of error to get you where you need to go.

As you venture to the Internet to determine how much you'll need, first make sure you understand the inputs that make a good retirement calculator.

Your Spouse's Holdings

For example, your spouse's Social Security is an essential part of your savings plan; without factoring it into your overall calculations, a typical retirement calculator could be overestimating how much you should be saving.

Marital status also affects your taxes, income and qualification limits for individual retirement accounts, making it a vital factor in putting together your plan.

For instance, you can't contribute to an IRA if you don't have taxable compensation. But if your spouse does and you're filing a joint tax return, then you may be eligible.

Without factoring this in, you might be getting inaccurate advice about the accounts to which you should contribute. (Read the IRS rules about IRA contribution limit.)

Where You Want to Retire

Figuring out your retirement spending depends on exactly where and how you plan to live after you have stopped working.

Adjusting your plan at a ZIP-code level is critical for getting an accurate idea of how much you will actually need in order to support your lifestyle.

For example, if you plan on moving from Raleigh, North Carolina, to retire in New York City and you factor in Broadway shows and art museums as part of your second act, your cost of living will more than double. But do it the other way around -- move from New York to Raleigh -- and your cost of living decreases considerably.

Changes In Spending

Some calculators look at your current income and then ask you questions about future spending patterns, such as, "Do you plan to be frugal during retirement, or will your spending be similar to what it is today?"

The answer to that question is not only hard to know years in advance of retirement, but it's also missing a key point: Regardless of whether you're more or less frugal during retirement, the amount of money you need will change. Once you're retired, you're no longer saving as much, so you don't need as much after-tax income to support the same lifestyle.

Research from the American Economic Association and National Bureau of Economic Research has shown that the wealthy often consume less than half of their net income because of taxes and savings. For example, according to our calculations, a single person living in New York with a pretax income of $1 million a year can assume that just over $410,000 of that goes to taxes and about $300,000 goes to savings and investments.

That means the amount you're spending is just less than $300,000, making it a good estimate of what you'll want to spend per year in retirement. (This hypothetical scenario refers to retirement spending, not retirement income, and doesn't factor in any expected salary increases.)

"Rather than planning for the average market return, it's smarter to plan for an outcome that may be a bit less rosy but that will leave you with more security in the case of a market downturn."

Taxes During Retirement

When it comes to taxes, not all retirement accounts are created equal.

With a traditional IRA or 401(k) plan, you pay taxes on each withdrawal in retirement. With a Roth IRA or Roth 401(k), however, there are no tax implications upon withdrawal when you reach your full retirement age.

That means if you're only ever contributing to a traditional 401(k) or IRA today, your retirement tax bill is going to be much higher than if you're saving in Roth accounts. Unfortunately, most retirement calculators don't take this into account.

Find a calculator that factors in state income tax. In order to estimate your average tax rate during retirement, it's important to get an estimate of what your state tax burden will be on top of your federal tax. By not doing this, you may underestimate tax on withdrawals from your portfolio.

Transparency About Market Uncertainty

Some calculators give advice based on a constant average return, obscuring the fact that what may actually happen in the market over a 30-year period is very uncertain. Rather than planning for the average market return, it's smarter to plan for an outcome that may be a bit less rosy but that will leave you with more security in the case of a market downturn.

Changing the average return in a calculator isn't a great way to do this, because it obscures the volatility you might experience along the way.

Keep in mind that if your investments are properly adjusted for this risk, then you can likely plan for a not-so-great outcome. However, make sure to update and adjust your plan as you know more about the market returns you've experienced.

By dynamically updating your plan and tracking whether you're on the right path, you can ensure you'll always have at least as much as you want, if not more, should markets cooperate.

-By Jon Stein, founder and CEO of Betterment
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