Couple paying bills in living room © Jose Luis Pelaez Inc, Blend Images, Corbis

As you contemplate retirement, you've probably heard that you should plan to live on 80% of your current spending after you leave work. Forget that rule of thumb.

The only way to get a realistic picture of how much you're likely to spend in the future is to create a retirement budget now. You can even plan for the unexpected -- say, the adult child who may need a large cash infusion at some point. Mulling every possible expense could help you create a withdrawal strategy that will protect your nest egg from the vagaries of life. And the budget exercise is "a great opportunity to start thinking about how you want to spend your time in retirement," says Judith Ward, senior financial planner and vice-president of T. Rowe Price Investment Services.

The first step is to take your current take-home pay and make adjustments, perhaps subtracting commuting costs while adding money for travel. This "top-down" approach will give you an idea of how much you may need soon after you retire.

To dig even deeper, use the "bottom-up" method, by developing an estimate for each spending category. You can use a detailed budget worksheet that covers most expenses. This from-scratch approach provides a better starting point for projecting how expenses could change over time. Even if you're already retired, creating a budget, and updating it regularly, can help you stay on track for years to come.

James Miller, president of Woodward Financial Advisors, in Chapel Hill, N.C., asks clients who are within two years of retirement to fill out an expense worksheet. The 100 line items include payments for gasoline, life insurance premiums, food, charitable giving, dining out, cable TV, pet care and club dues. "It's crucial that the expenses are accurate," Miller says. "If your expenses are off by 5% a year, it may not be a killer, but if they're off by 10% or more, that could make a big difference compounded over 30 years."

Review all of your expenses for an entire year, not just for a few months, says Steven Medland, a certified financial planner with TABR Capital Management, in Orange, Cal. "Many expenses are paid out once a year, such as homeowners insurance," he says.

Some expenses, such as a mortgage, will end, but you may need a new roof at some point. You may cut back to one car, but you'll likely need to replace it.

You can review your credit card bills and checking account. The most accurate way to track expenses is to use software such as Quicken or an online budgeting tool such as Mint.com.

Also, split your expenses between the essentials and the discretionary. Peg McMahon, 66, uses two Mint.com accounts, one to track her personal costs and the other for household expenses she shares with her partner. "It turned out we had underestimated what we were spending on groceries and cat food," says McMahon, who lives in Kansas City, Mo., and works as an information technology technician for Sprint.

McMahon expects to retire in several years. By noting every expense, she says, she'll have a better idea of what she will need in retirement and what she can cut out. After seeing how much she was spending on books, she stepped up her visits to the library. McMahon hopes to cover all essentials, such as food and an Internet connection, with Social Security and pensions. "One of my desires is to live now on what I will have in retirement and sock the rest away," she says.

Have health, will travel now

The difficulty is figuring out what your costs will be down the road. Many retirement researchers and financial planners agree that annual spending for most retirees tends to decline over 30 years, after adjusting for inflation. "As people age, they don't travel as much and they are not as concerned with spending on fashion," says Ty Bernicke, a certified financial planner in Eau Claire, Wis. Bernicke conducted a major study in 2005 on the spending decline.

Financial planners often refer to three stages of retirement spending as "go-go, slow-go, no-go." First, there are the heady years of travel and new hobbies, when spending can surpass the preretirement lifestyle budget. In a person's seventies, retirement settles into a routine, with lifestyle spending declining while health care costs begin to creep up. After 85, some healthy octogenarians do embark on expeditionary travel, but most seniors spend little on leisure, clothes and other discretionary expenses, many financial planners say.

In the last stage, health care costs consume a greater share of a retirement budget – 18 percent for those over 85, compared with 9 percent for those 50 to 64, according to an analysis by the Employee Benefit Research Institute. That analysis, however, did not include most spending on long-term care -- the real wild card in projecting future costs. "Spending on travel and entertainment does decline with age, but you have to assume that both declines will be offset with increases in other categories," says Wade Pfau, a professor of retirement income at the American College, an institution for financial professionals, in Bryn Mawr, Pa.

In designing a realistic budget, retirees need to factor in inflation. Assuming a 3 percent annual increase in costs, groceries that now cost $5,000 will run about $10,500 in 25 years.

Retirees who want to go a step further can factor in different inflation rates for different types of spending -- and then make adjustments based on spending habits by age. Research by Somnath Basu, a finance professor at California Lutheran University in Thousand Oaks, Cal., looked at a 30-year retirement divided into "age bands" -- 65 to 74, 75 to 84, and 85 to 95. He divided spending into four general categories: taxes, basic living, health care and leisure. He then assigned an inflation rate for each category -- 7% each for health care and leisure, and 3% for taxes and basic living.

Basu also adjusted each spending category for each age band. For example, he assumed that taxes, adjusted for inflation, would drop by half, with the end of payroll taxes and a decline in taxes on salaries, and then would remain steady. Basic living costs (which include transportation, housing and food) were assumed to drop by 30% after retirement, fall another 20% at 75 and then by another 10% at 85.

Leisure activities increased by 50% in the first years after retirement, and then dropped precipitously. Meanwhile, health care posted a rise of 15% at retirement, another 20% at 75 and 25% more at 85. His conclusion: You can't assume that overall spending will decline over the years.

But Michael Kitces, director of financial planning at Pinnacle Advisory Group, in Columbia, Md., says such increases in health care "can't go on indefinitely." And, he says, "you will drive yourself nuts" if you try to apply a different inflation factor for each line item. (If you'd like the challenge, the U.S. Bureau of Labor Statistics shows percentage changes in consumer prices (.pdf file) for people age 62 and older from 1998 to 2009.)

Kitces also says that the Medicare program will continue to protect retirees from much uncertainty over costs. A married couple today typically pays more than $8,700 a year for premiums for Medicare Part B, a Part D prescription-drug plan and a Medigap supplemental insurance policy. Medicare, Kitces says, has "eliminated almost every unexpected expense." Medicare doesn't pay for everything, so plan for out-of-pocket costs for vision and dental care.

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