People often ask, “How much money do I need to save before I can retire?”
Predicting how much you need depends on a number of factors, including how much you will spend each year, when you will stop working, and your sources of retirement income. In addition, you need to know the growth rate of your savings and investments, the inflation rate, and an estimation of how long you will live. Most of these variables can’t be predicted with certainty. However, you still should prepare a plan and then reassess your plan each year. It is
better to plan ahead than risk outliving your money.
There are many ways to estimate how much you need to save before you retire.
FinancialMentor.com recommends the following steps:
1. Estimate how much you will spend annually in retirement (retirement expenses). Keep in mind that even though some of your expenses will decrease once you retire (commuting and work attire), other expenses will increase (travel and potentially significant medical expenses). Common guidelines predict that you will spend 70%-80% of your pre-retirement income per year during retirement to maintain your standard of living; because of the many variables noted above, I recommend using a percentage of 100% of your pre-retirement income to estimate your retirement expenses.
2. Estimate your retirement income including social security, pensions and annuities (retirement income). The Social Security website (ssa.gov) provides a good estimate of your benefits.
3. Subtract your retirement income from your retirement expenses. The difference is the amount that needs to be covered by your retirement and non-retirement investments (savings).
4. Estimate the growth rate of your savings and the rate of inflation.
Please note that this estimate assumes a 30-year retirement and does not include the effect of income taxes.
An example will hopefully make the preceding steps easier to understand. Assume your pre-retirement income is $75,000/year, your social security benefits and pension will be $25,000/year, you will earn a 7% investment return, and the rate of inflation will be 3%.:
a. Income ($75,000) less Social Security and pensions ($25,000) equals $50,000, the amount that needs to be covered by your savings.
b. $50,000 divided by 4% (investment return 7%-inflation 3%) equals $1,250,000, the size of your savings needed before you retire to cover your retirement expenses.
There are other ways to estimate how much you need to save before you retire. The Rule of 25 estimates how much money you need in your retirement savings by multiplying your annual retirement expenses by 25. The 4% Rule estimates how much you should withdraw from your retirement savings: withdraw 4% from your retirement savings in the first year of retirement and withdraw the same amount the next year, adjusted for inflation. In addition, there are many retirement calculators online that can help you predict how much money you need to save for retirement and/or how much you can withdraw each year.
If your projected savings will not be able to cover the difference between your retirement expenses and your retirement income, you will have to aggressively save and/or cut living costs. The risks of not having enough money in retirement savings include a stock market drop, higher
inflation, a longer life expectancy, and spending too much too soon. There are ways to address these risks, including spending less and saving more prior to retiring, delaying retirement, working part-time during retirement, lowering your living and housing expenses, and adjusting your withdrawal rate.
There is no magic number to answer the question, “How much money do I need to save before I can retire?” because of the many variables and assumptions. My advice is to make saving for retirement a priority during your working years, monitor your actual spending and savings during retirement, and make adjustments each year to ensure that you have enough money to last through your retirement.
Look out for next month’s article for ways to cut spending to help you save enough money to retire.
Beth Carroll is a CPA and a Professional Daily Money Manager. Her company, Cornerstone Money Management, LLC, helps seniors in their homes with billpay, financial organization and cash flow management. You may reach her at email@example.com or 401-323-4895.