Tax-Deferred Retirement Savings: Positioning Yourself to Spend Less

In a recent post, I discuss the feasibility of retirement at an early age. The main point of the article is this: the more you save today and the less you can live with after you retire, the earlier you can kiss your job goodbye! But hold on a second...If I'm already sacrificing by saving as much as I can now, how can I be expected to live at an even lower standard of living when I retire? You can. And here's why:

Planning for retirement means more than just putting money into a 401(k) or some other type of retirement account. It also means positioning yourself to withstand many years of little or no income. It means preparing your finances so you'll incur fewer expenses after you retire except, of course, those checks in your grandchild's birthday cards.

In addition to saving for retirement, which will ensure you have lots of money at your disposal, you should also take steps to ensure that you'll have fewer expenses. As I mentioned in my previous post, a 10% reduction in spending each year during retirement could mean the difference between going through all of your principal savings and going through none of it.

So am I saying to head to Costco and fill a couple of industrial-sized freezers with 30 years' worth of food? No. What I am saying is to think about your big expenses. Pay off your house. Pay off your vehicles. Save enough to pay for your kids' (or grand kids') college. Have a tradeable timeshare (or two) paid off.

There are two main reasons to position yourself to have reduced expenses during your retirement:

1) You'll be able to live off less income during your golden years. By reducing the amount you consume each year of retirement, the longer you'll be able to live off of your nest egg. I'm a proponent of reducing debt today so you can save more money. I'm an even bigger proponent of reducing debt so you won't have to pay as much tomorrow when you're certainly going to have less coming in.

2) If you can live off less during retirement, you'll fall into a lower tax bracket. If you work hard to ensure that your expenses will be reduced when you start drawing from your tax-deferred savings, you won't need to draw as much money per year and will therefore pay a lower tax percentage. If today you earn $100,000 per year, you need to pay taxes on all of that money, less your deductions. If when you retire you continue to draw $100,000 from your pre-tax 401(k) each year, you'll pay the same taxes when you withdraw it.

But if you make $100,000 per year today, will you need $100,000 per year when you retire? Probably not. Let's make a few assumptions. Currently, you're saving $20,000 pre-tax dollars for retirement. And you're spending $1,500 per month on your mortgage. And you're spending $500 per month on your car loan. Given these assumptions, your monthly take-home pay will be about $5,000, depending on your state. If you pay off your mortgage and your car prior to retirement, you will reduce your post-tax spending by 40% ($2,000/$5,000). And let's not forget that after you retire, you won't need to save money for retirement.

So theoretically, you could live a lifestyle comparable to the one you had when you were working with $3,000 per month. And if you end up getting social security, you'll need to draw even less from your 401(k); but I don't really believe in social security. So if you drew $50,000 of your pre-tax dollars from your 401(k) annually, you would end up with about $3,200 per month, post-tax -- more than what you had left over after the mortgage and the car payment when you were making $100,000.

Because you're drawing much less, you're put into a smaller tax bracket. The way that you're able to draw less is by making smart decisions while you're working. After you retired, if you were able to cut your annual "salary" in half by living off of $50,000 rather than $100,000, imagine how much less you could live off by "prepaying" even more of your post-retirement expenditures. Want to travel as a retiree? Buy a timeshare or two that you can trade. Need to pay for someone's college when you're retired? Save the money in a 529 beforehand.

People don't spend less during retirement because they eat less or because things get cheaper. They spend less because they have positioned themselves to spend less by paying off their future obligations early, like a home, a car, a vacation spot, and college.