How much money do you need to retire? Of course, part of the answer depends on how you invest your money and how much income those investments generate. But you may be surprised to discover that a far more important determinant of retirement success is your spending. In any case, we’ll handle both these subjects.
But let me give you some good news to start things off. You can determine how much you need to retire without paying someone thousands of dollars to create a fancy financial plan that doesn’t make sense to you anyway. Go through the following steps to do your own calculations. At the end of this exercise, you still may want to run some more sophisticated projections based on what-if scenarios, but at least you’ll know where you stand. And you’ll gain some insight into what you need to do in order to make your nest egg last longer. Let’s get to work.
If you ask me how much money you need to retire, I need to know what it costs you to live now. I realize that we’re talking about future spending and you will have to make an educated estimate of what you’ll be spending down the line. But you can’t do that without first knowing what you’re spending now. Then you can use what you spend now and adjust for inflation. Don’t kid yourself into thinking your spending will decline when you retire. It won’t.
Neal’s Notes – Looking for a way to slash your housing costs during retirement? Consider a CCRC as a retirement residence. This move can free up a ton of cash so you can spend and enjoy – and offload the problem of living assistance down the line.
When you retire, you have more time to spend money and that’s what you will do. You’ll travel more and if nothing else, you’ll shop out of boredom. That’s what happens (unless you develop retirement hobbies that don’t cost much but could possible make you a bit of extra cash.)
Also, as you get older, you may have to help your kids, grandchildren and you will probably spend more for medical expenses.
Most people don’t really know how much they spend now and they are intimidated by the prospect of tracking all their expenses. If that describes you, don’t worry. A simple method is to average your total bank withdrawals over the last 24 months and keep track of this number. You can use more detailed software programs but the bank statement method is very helpful and only takes about 5 minutes a month to do.
For our example, assume you’ll spend $80,000 a year when you retire – as adjusted for inflation. We’re ready for the next step.
Neal’s Notes: Another crucial determinant is whether or not you take a lump sum from work or accept a monthly income payout. This decision can make a huge difference in when you can retire – but think carefully. You may be able to to retire sooner by accepting the monthly payout. But because that monthly income has no inflation adjustment, you may be putting yourself at greater long-term risk by going this route.
2. Existing Income Sources
When you retire, you’ll have social security and possibly a pension. There are also many overlooked ways to bring in extra cash after you retire. How much income will you have? (Keep in mind that while you calculate your retirement cash flow, you have to consider whether or not you rely on that income going forward. That is a separate yet highly important topic on it’s own.)
For our example, let’s assume you’ll have social security and pension income of $30,000. You can see that this person needs to come up with an extra $50,000 in order to meet her annual income needs.
3. Do the Math
We know that this person will need an extra $50,000. Now we have to figure out how much to invest in order to create that $50,000. That answer is the amount needed to retire for this individual. This isn’t difficult to do at all.
Take your $50,000 short fall and divide it by the return you think you’ll earn on your investments over the remainder of your life. I use 5%.
Using 5% might seem like a high number right now. Rates are indeed much lower now but it’s not reasonable to expect that rates and returns will remain this low over the remainder of your life. That’s why I recommend using 5%.
So, if we take $50,000 and divide it by 5% – you get $1,000,000. That means you have to have accumulate $1,000,000 by the time you retire in order to create that missing $50,000.
4. What have you saved so far? How much will it be worth when you retire?
Let’s say your total savings (including your retirement accounts) is worth $300,000 and you need to get to $1,000,000 by the time you retire in 20 years. Of course you’ll need to make smart investments to reach your retirement goals. And the best way to get that savings built is to automate your retirement plan. But let’s not worry about how to invest the money at this point.
You can use any number of financial calculators to determine what that $300,000 will be worth in 20 years. Let’s assume that you determine that the $300,000 will be worth $800,000. You now know you are $200,000 short.
Again, use any financial calculator to determine how much you’ll need to invest each year, over 20 years with an assumed rate of return, in order to reach your goal of $200,000.
This is not all that complicated if you take it one step at a time and break down the question into smaller questions.
This is an example of a very straight forward case. If your situation is more complex, don’t fret. Many people have various levels of complexity and are still able to run these calculations. You are looking for a basic idea of where you need to be. We’re not looking for perfection here Pilgrim.
Keep in mind that it’s a good idea to run these calculations once every year or two. That’s because your situation is likely to change over time. One of my favorite clients in Arizona created a spreadsheet that ran 15 different scenarios and I was super impressed. He did this all himself with Excel and you can too. But you don’t have to go crazy. Use this simple step-by-step process to figure out how much you’ll need when you retire. The only thing you have to do is ask the right questions.
How much do you need to retire? Have you done your calculations?