Tracking Living Expenses
In starting out a new year, another important activity for people nearing retirement to get in a habit of doing is tracking living expenses. Most people are aware that they should do this, but may need some tips on how to put this practice into action. In this post I will explain how I do this.
Tracking your living expenses is a good idea for people of any working age. When you are younger, it is very important that you are saving money at the proper rate in order to meet your retirement goals. Review the “Recommended Annual Savings Rate” Table in this post for a rough guideline of required savings based on your current age, current savings, and income. (NOTE: the table in this post assumes retirement at age 70. If you want to retire at age 60, you must add 10 years to your current age).
In reviewing this recommended annual savings rate table, most people find they need to increase their savings rate. This of course requires people to make changes to their current spending. If you find you need to increase your savings amount, having an easily generated report available that captures your annual living expenses into several important categories, allows you to review where your money is being spent. This, in turn, allows you to make informed decisions about where you want to trim your expenses in order to increase your savings rate.
If you are within 10 years of your planned retirement date, tracking your living expenses is your most important day-to-day retirement activity. This data allows you to estimate your annual living expenses in retirement. This estimate is important for two reasons. First, to determine if you are on track to save enough money to retire based on the 4% rule (the amount saved for retirement = your required annual living expenses divided by 4%). Second, you must have a good handle on your retirement living expenses to set up your retirement withdrawal strategy.
When you are close to retirement, many of your mid-life expenses should be ending, e.g., child rearing costs and your home mortgage loan. Your expenses should start looking similar to what they will be in retirement. If you track your living expenses, you can use this data to make some adjustments and estimate what your living expenses will be when you actually retire. A few examples of these living expense adjustments are: the amount you save every month will drop, your payroll taxes will disappear (unless you work part-time in retirement), and your work related expenses will disappear. Of course, some costs may increase such as your out-of-pocket costs for health care services and recreational expenses.
It is really easy to track your living expenses using commercial software products available today. I use Quicken Software developed by Intuit, Inc. which only costs about $30 for their base product called “Starter Edition 2012.” This base product is all you need and it is money well spent. There are other financial products available from other companies as well. I have not used any other products, but I am sure they will all do the job. I have used Quicken for over a decade and it has been very helpful. You should check several products and choose the one which works best for you. It’s important to select a product you are comfortable with, because you will need to purchase an upgrade to the product every 2 or 3 years and using the same product allows for a seamless upgrade.
I cannot speak for how other software products work, but what I like about Quicken is that after you install the product, it requires no more effort to use than the old style paper checking account register. The reason for this is when the Quicken software is opened on your PC; you enter each transaction into it the same way you would enter data into the old fashioned paper checkbook register. You also use the software to balance your checking account against the monthly bank statement you receive just like you do in paper form. Account reconciliation in Quicken only takes me about 10 minutes every month.
We purchase one copy of Quicken software about every 2 years, and we keep my checking account, my wife’s checking account, and a separate checking account for each of our rental properties on this one copy. The checking accounts do not have to be at the same bank. My wife’s account is at a different bank. So this means I get a separate bank statement for her account when I do the monthly reconciliation in Quicken.
After installing the software, the only other work required to begin tracking your living expenses is creating the income and expense categories that you will want to capture all your account deposits and outgoing payments. This is an important step. Creating these categories is the main reason for using the software. To make setting up the income and expenses categories easier, Quicken software comes with a generic category list that you can modify for your use. The category list supplied with the software is very detailed. Unless you want to be really detailed with your finances, I don’t think all the categories are necessary. I only have 8 income categories and 30 expense categories. The table below shows the list of income & expense categories I customized for our use in tracking our annual personal income & expenses. (I use a different category list for our rental properties). I have used this simple list for over a decade. You should create a list of category expenses at a level of granularity that is suitable for your purposes.
After you have created the income and expense categories, you are ready to use the software just like you would any paper check register. The only difference is that each time you enter a deposit or a payout into the check register; you click on a drop down menu to choose the category that the deposit or expense will be “assigned” to. The first time you do this you may have to think for a second what category is appropriate for each entry, but after using the software for a month or so, selecting a category for each transaction will be second nature. You’ll find that 95% of your monthly expenses will be the same. Every once in a while you will have a new expense that will not fit into a category. If this expense is a one-time small item I just assign it to “Misc Costs.” If it is a new re-occurring expense, then I create a new expense category for it. (Note: Be sure your spouse is categorizing all expenses the same way in her checking account for consistency).
The reason for assigning all income and expenses to a category is so you can generate a report summarizing all your deposits and payments for any time period that you request. You can run a report for each individual checking account or all accounts together to review where your money is being spent. This report is what you use to scrutinize all your expenses and decide where to make adjustments if necessary.
Many credit cards, as part of their monthly statements, allow you to categorize your credit card expenses. I do not use this credit card feature because it does not allow me to capture all methods of payment in one place. For example, your credit card does not capture any checks you may write or an Electronic Funds Transfer (EFT) you may initiate out of your checking account. This is why it is best to use your checking account as the financial instrument to capture all expenses.
For airline miles and other rewards purposes we put almost every expense on our monthly credit card bill which we then pay (in full) out of my checking account. Quicken has a feature where you can enter and categorize every credit card expense as it is incurred within the single monthly credit card bill payment. So, in reality, every month I go through two reconciling activities. First, I balance my monthly credit card expenses within the one checking account transaction that is my monthly credit card payment. Second, I reconcile my monthly checking account statement which contains debit card transactions, checks written, etc. My credit card payment is just one entry in the checking account. In this way Quicken captures and categorizes every expense in one place.
There is one final important thing to remember regarding tracking your living expenses. If your earned income is deposited in your checking account as “after tax” income, this means that the software is not tracking any tax payments. This is just as well as your tax liability will likely be very different in retirement. In any case, when you generate reports to estimate your retirement living expenses, you must add an estimate for any state and federal taxes that may be owed. The 4% safe withdrawal rate is a gross figure that includes any tax liability.
The reason for this blog post is to stress the importance of tracking your living expenses. If you are not already doing this, you should start this activity yesterday. This data is necessary to determine your retirement income needs and allows you to set up your withdrawal strategy to fund them. I will be discussing withdrawal strategies in the next few posts.
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