Before buying your parents' house, calculate its effect on retirement

Dear Pete,

My wife's parents are moving to a retirement community and would like to sell us their house. The house would be about $45,000 more than ours and has some charming features. It needs a lot of renovation/redecorating ($60-$80K worth). We're about 7-10 years from retirement ourselves and have the money to pay cash for the house once we sell ours. In fact, our son says he would like to buy our house. We don't want to act on sentiment alone in making this decision. We have about $500K in cash/retirement savings. Any thoughts?

Sean, Lincoln, Neb.

Answer: That’s one way to save on real estate commissions – just keep it in the family. In my opinion, this is the perfect financial question. If handled correctly, your decision will make great financial sense and you will derive meaningful pleasure from it. If handled incorrectly, you’ll try to convince yourself you made the right decision despite actually compromising your financing stability for decades to come. The stakes are high, and the answer lies buried deep inside your retirement plan.

So, in reality, this housing question is actually a retirement question. Fast-forward 10 years. What does your retirement income look like? How is it structured?

Grab a calculator. It’s math time.

Begin by examining your current lifestyle and using it to project your future retirement income needs. For instance, if currently you're comfortable living on $80,000 per year and want to continue with that income in retirement, then you need to calculate how much it will actually cost to live on a 2019 $80,000 income in 2029. Yes, inflation is the factor here. Based on the last 10 years of consumer price increases, you will need about $95,000 of income in 2029 to get that 2019 $80,000. That’s roughly a 20% increase. I’m going continue my example using $95,000, but you can arrive at your real income need by increasing your current income need by 20%, given that you’re trying to project its value 10 years out.

The next step is to determine how you’re going to come up with $95,000 year after year. If you or your wife will have pension income 10 years from now, subtract that annual income amount from $95,000. Next, if you and/or your wife plan on collecting Social Security retirement benefits 10 years from now, subtract those amounts from whatever’s left after subtracting your pension income from this hypothetical $95,000.

At this point, ideally, you have a much smaller annual income need than what you started with. If you needed $95,000 to start, had a $40,000 pension and a $45,000 worth of annual social security payments, then your unfunded income shortfall just shrank to $10,000.

However it’s possible you don’t have a pension, and therefore your unfunded income need becomes $45,000. To determine whether or not your retirement assets are enough, multiply your projected unfunded income need by 25. In this scenario, $45,000 multiplied by 25, equals $1,125,000. You would need $1,125,000 in retirement assets 10 years from now to successfully retire. We’ll call this your magic number.

Once you plug in your real numbers and are confident your retirement will be properly funded, then go ahead and bring your housing question back into play. If using your current assets tagged for retirement to make the purchase, and using future work income to pay for the renovations will prevent you from getting to your magic number, then don’t buy the house.

It really is that simple. If the math doesn’t work, don’t do it.

When you’re seven to 10 years out from retirement, big decisions, like a housing decision, can literally ruin everything you worked for if you don’t run your retirement numbers before and after the decision at hand. Giant weddings, funding college, starting a business or moving can throw your math into disarray. Too often people make these emotional decisions based on a gut feeling and not the math.

You can derive confidence from math; it’s harder to rely on confidence brought on by a gut feeling.

This article is published courtesy of USA Today.