How much is enough? We all ask that question and feel like there’s no answer – but there is! Last time I laid out a step-by-step guide for calculating how much is enough for events and projects like buying a house or going on a trip. Now let’s talk about what’s probably the biggest savings projects you’ll undertake: retirement.
Saving for retirement often feels too big and scary to even think about. But it doesn’t have to be that way! Let’s break it down into bite sized, manageable pieces.
Saving for Retirement
Figuring out retirement savings is similar to what we just did last time, but it has a few differences. First, it can be hard to calculate how much we need to save. Second, taxes and interest rates are part of the equation. And on top of that, there’s no way to be sure how long any of us will live. Still, there are some ways to make plans around educated guess and research that’s already been done.
Keep in mind, everyone needs a retirement plan. Maybe you’re expecting a big inheritance, but what if it never comes? Some people tell me they plan to work until they die, but your body doesn’t always allow that. What if you become too ill or disabled to work, yet you live another 30 years? You might be expecting a pension from your job, but those sometimes fail.
Many people ask me about Social Security. I don’t have a crystal ball. I don’t know if it will be around in 20 or 30 or 40 years. You can go here to learn how much you are currently entitled to. Personally, I’m not counting on receiving Social Security in retirement, just in case. Then if it works out, great! And if it doesn’t, I’ll still be ok. But you have to do what you’re comfortable with.
There’s a lot of advice to save 15% or 20% or your income each year. I think that’s good, simple advice that’s relatively easy to follow. But there’s a lot it doesn’t take into account. The plan below gets more specific. If you worry that saving 20% isn’t enough, or if you think 15% is too much, go through these steps to get a clearer idea of where those numbers might lead you.
Step 1: What kind of retirement do you want?
Take a few minutes to think about what you want. Do you want to leave a legacy to your children? Do you want to spend down all of your money? Do you want to live a life of luxury after you retire? Do you want to keep things simple after you retire? Look at your parents and grandparents: how long did they live? How was their health? How active were they? Did they need home healthcare? Do you want a similar lifestyle to theirs or do you envision something different?
Your answers to these questions will change over time, so revisit them occasionally. These aren’t meant to give you a definitive monetary goal, but to help you in the next step.
Step 2: Budget your retirement
Figure out how much you spend right now. With that in mind, create a budget for 2 different years of retirement. The Year 1 will be representative of your early retirement years, maybe age 66 or so. Year 2 will be representative of your later years, maybe around age 85 or 90. Don’t worry about inflation right now. Use today’s prices.
Side note: There are rules of thumb for calculating your retirement budget (such as 85% of your pre-retirement income) but the problem is that even if that might be accurate for you right before you retire, if you’re 40 years away from retirement then your life and budget probably look very different right now. That’s why I prefer to budget each line item instead of using a formula.
You’re going to have a lot of free time. How will you spend it? Will you travel a lot? Babysit your grandkids if you have any? Begin new hobbies?
Put aside money for your health. Medicare covers a lot, but it also leaves out a lot. Down the road you might need to move to a wheelchair-accessible apartment. Maybe you’ll move into assisted living, which can easily cost $8000 per month or more. This could happen at any point in your retirement, but it should definitely be considered in your Year 2 budget.
You’ll also take some things out of your budget. You won’t need fancy suits for work. You won’t be commuting. You won’t be saving up for your kids’ college funds, but maybe you’ll want to help pay for your grandkids’ education. At some point you might stop traveling.
What about other costs? Will you buy a new car every 10 years? Will you want to give big gifts to your family? Maybe you’ll pay for your kids’ plane tickets every time they visit you.
Like you do for your budget now, list out different categories, then estimate an amount for each one. What’s the total for each of your sample years?
Step 3: Determine a yearly budget of expenses
Your budgets for those two different years might be similar or they might be completely different. Use the higher number, but lower it slightly if they’re really far apart. If budget #1 is $50,000 per year and budget #2 is $60,000, then let’s use $60,000 per year for your yearly expenses.
Step 4: The 4% Rule
A study was done in the 1990s to determine how much someone can withdraw from their retirement account without running out of money. The answer was that most of the time, withdrawing 4% per year would make your money last for your entire retirement. There has been a lot of controversy about this. Personally, I’m a fan of using the 4% rule as a baseline and then adjusting it. If you feel that 4% is too risky, try 3.5% or 3%. If you think it’s overly conservative, maybe 5% is better for you.
Use the links above to check out the 4% rule for yourself. Find the number that feels right. If you’re not even close to retirement and you just want to play around, then use 4% for now to start getting a feel for the numbers.
Step 5: Find your magic number
In Step 3 we decided to use an example yearly budget of $60,000. And we decided to use the 4% rule. Do you expect to get regular income from any sources besides your retirement account? Write those down. Now it’s down to math. (Substitute your own numbers in the formulas below.)
Scenario 1: In this example, you need $60,000 per year. Let’s say you expect to get $25,000 from Social Security and/or a pension. That means you need 60,000 – 25,000 = $35,000 per year from your retirement account. What size does your retirement account need to be to produce $35,000 per year when you withdraw 4%? When you do the math, 4% is 0.04
35,000 / 0.04 = $875,000
So in this scenario you need to save up $875,000 for retirement.
Scenario 2: We’re still aiming for $60,000 per year but this time you don’t expect to get any income, so you need all of your money to come from your retirement account.
60,000 / 0.04 = $1,500,000
In this case, you’ll need to save up $1,500,000 for retirement.
Step 6: Determining how much to save each month
Now you have an idea of how much you need to save up in today’s dollars. There are plenty of calculators online that will tell you how much you might need to save after taking inflation into account. (Inflation is the increase in prices and the fall in the value of money over time. It’s the reason a cup of coffee cost 10 cents in the 1960s and now it’s $3.)
Now decide when you’d like to retire. 65 is a common age, but maybe you’d rather retire at age 50. What’s your goal?
If you’re going to retire in just a few years, you’ll do some simple division. But if your retirement date is farther out, there are some other variables to take into account. A big one is investing. If you invest the money, you might receive interest on it. We’re going to use 7% interest in this example. (Some people prefer to calculate 5%, 10%, or some other number. I chose 7%. There’s no guarantee what your average interest earnings will be, or if you’ll receive any at all – the best you can do is estimate.)
Side note: Different retirement accounts (like a 401K or a Roth IRA) give different tax benefits. I’ll review those in a separate post.
Scenario 1: Let’s say you’re planning to retire in 40 years (480 months) without earning any interest, and let’s say you need to save up $1,500,000 (see Step 4.) Then you need to save
1,500,000 / 480 = $3125 per month
Scenario 2: Let’s assume the same numbers as in Scenario 1, but this time you expect to average 7% interest. I’ll skip the math here (but you should play around with it; a good compound interest calculator is here) and just tell you that you’d need to save
$666.66 per month.
The point is that there are a lot of variables that can vary widely, but your biggest friend is time. The sooner you start saving that large amount of money, the safer you’ll be later on thanks to compound interest, which I’ll discuss in an upcoming post. Saving early will cushion you if you need to slow down later because of unemployment or some other expenses. It will also help if you decide you’ll need more in retirement than you had originally planned.
To see how much you could be putting towards retirement right now, check out this free calculator I created:
Step 7: Will it really be enough?
There’s no guarantee that your retirement calculations will be accurate. You can’t be sure when you’ll retire or what your lifestyle will be. There’s a lot beyond your control. The best you can do is prepare as much as possible and these steps give you a solid basis for saving what should be enough to get you through those golden years. Start now and you’ll be in a much better position when the time comes. When you need some encouragement, remember that if you don’t save anything, then you definitely won’t have enough for retirement. Then feel good about the progress you’re making!
Now you have the tools to figure out how much to save for your retirement. Like with any other saving, it is up to you to use these tools. Get the free compound interest calculator and begin playing around. Make a plan and take control of your future! And if you found this post helpful, please share it so others can benefit, too!