A quick estimate of overall spending can be compared to the ballpark estimate of expected retirement income we just calculated, letting us know if we have a retirement funding problem and how big it might be without having to generate a detailed budget first.
Second, after you create that detailed budget, the mortgage, utilities, groceries and other categories should add up to a number pretty close to the overall spending estimate. If it doesn't, you're double-counting or omitting some of the categorized expenses. It's a good way to cross check our figures.
The pay stub will quickly show your gross income, how much you paid in FICA taxes, and how much you withheld for taxes. Your withholding was probably more or less than your actual taxes, though, resulting in your having written a check to the IRS or having gotten a refund, so your tax return is a better place to find your actual taxes paid. Don't confuse the amount you had withheld from your paycheck with the amount of taxes you actually owed. Only the latter is relevant.
Your pay stub will also show how much you saved in 401K, Flexible Spending Accounts and similar savings accounts.
Lastly, identify any additional savings for that year. Did your checking account balance grow substantially by the end of the year? Add that to savings. Find the January 1st checking account balance on your January bank statement for that year and subtract the December 31st balance reported on the December statement. The same goes for any savings accumulated outside your company retirement savings plan that wouldn't show up on the pay stub.
The amount you spent for that year equals your gross income less any amount you saved. Let's say your gross income from your end-of-year pay stub (or W-2) was $60,000 and you paid $4,300 in FICA taxes. Your Form 1040 tax return shows you paid $9,000 in federal taxes and your state return shows you paid $3,000. Your pay stub shows your 401K contributions totaled $4,000.
Of course, a decrease in your checking account balance means the opposite. You borrowed from your checking account to spend more. If your balance decreased over the year, you must add the amount of the decrease to total spending.
You can also see from these figures that you paid $16,300 in Federal, state and FICA taxes, so your spending on everything except taxes was $37,700. You won't pay payroll taxes after you retire, assuming you stop working altogether, and your Federal and State taxes might be lower. In planning a budget for retirement, it's important to separate out expenses like this that may vary significantly after you retire.
Pay careful attention to "gross income" on your pay stub and make sure that your 401K contribution hasn't already been deducted from that amount. If it has been you are looking at taxable income, not gross income.
Also, the principal paid toward loans, including your mortgage, is technically a repayment of principal and not an expense. You're saving the money as equity in your home instead of cash in a savings account, but it's savings, nonetheless. The interest portion of the mortgage payments, the property taxes and insurance, on the other hand, are all expenses. You can subtract your total mortgage principal payments for the year from the $37,700 to get your true total expenses.
In our example, let's assume you check your end-of-year mortgage statement and determine that you paid $7,700 toward your mortgage principal during the year. Your actual non-tax spending was then only $30,000.
You may have had some extraordinary expenses (a kid in college, a new car) that will skew your annual spending estimate. Ultimately, these "non-recurring" expenses will need to be accounted for. You have to decide whether you will need to spend these amounts after you retire (you will probably buy a few cars over the years) or they are one-time expenses (like college tuition).
Second, knowing your total expenses is interesting, but it doesn't help identify how your expenses will change in retirement. To predict retirement cost this way, you need to know that you spent $2,500 on travel this year and plan to double that in retirement, and that you spent $5,000 on commuting expenses and will spend significantly less after we retire. You will no longer pay payroll taxes and you won't need to save for retirement. That requires a more detailed accounting of spending by category and I'll cover that in the next chapter.
The Key Points
- You can determine how much you spent in a given year by finding your gross income and subtracting how much you saved. Gross income can be found on your W-2, your year-end pay stub, or your tax return for that year. Taxes can also be found on your tax returns. Don't confuse the amount of taxes you paid with the amount of tax withholding shown on your pay stub.
- After subtracting what you saved and taxes you paid from your gross income, what's left is the amount you spent for the year.
- This high-level analysis of spending needs to be further refined before we can provide effective retirement planning.
If You're Playing Along at Home
If you are developing a retirement plan as you read these, find a recent copy of your detailed budget of current spending by category. If you don't have one, follow the steps above to begin developing one.
Here are the steps again:
1. Determine your gross income for the year by checking your W-2, Tax return (1040), or your final pay stub for the year. (GROSS INCOME)
2. Determine your retirement account contributions (401k, IRA, 403b, etc.) from your W-2 or other records. (SAVINGS)
3. Check your account statements for any additional savings you deposited in non-retirement savings accounts, CDs, investment accounts, etc. (add to SAVINGS).
4. Determine the change in your checking account balance by comparing your January and December bank statement. (If balance increased, add the amount of the increase to SAVINGS.)
5. Determine the amount of principal you paid by checking your mortgage and other loan statements. (add to SAVINGS).
6. Add the amount of Federal and state taxes you paid by checking the TAXES OWED lines of those returns. (TAXES)
7. Determine the amount of FICA taxes you paid by checking your W-2 or final pay stub for the year. (add to TAXES).
8. Subtract total SAVINGS and total TAXES from GROSS INCOME to calculate your SPENDING for that year.
9. If the balance of your checking account decreased through the course of the year, add the amount of the decrease to SPENDING.
10. Consider any large expenses like a new car purchase or college tuition. Once your children leave college, tuition won't show up in your future budgets. You will buy more cars, though, so you will need to convert that one-time cost to an annual amount.