How Much Do You Need To Retire? – Part 3
Over the past two weeks, we’ve talked about how common it is for people to wait until it’s too late to start saving for retirement. By now, you should understand the importance of putting money into your retirement account as early as possible to give compounding interest a chance to take over and turn your thousands into millions. I know people personally that have or are on track to retire by 30. Yes, 30 years old. Seems crazy right? Like everything, with smart planning, hard work, and self-discipline you can be one of them as well.
Now that we understand the process, we need to answer the next logical question; how much money do you need to retire? You may have heard before that you will need a million dollars to retire comfortably. The fact of the matter is, one million dollars may not cut it anymore. How much you will need all depends on the lifestyle you want in retirement.
The problem most people face is that they underestimate the amount they need to retire. In fact, there are retirees living this nightmare today and are being forced to return to the workforce in some fashion. Do you want to finally retire and then have to get another job 5 years down the road? Me neither.
The reason for this is quite simple. Number one, you have an unprecedented amount of free time and two, your health is getting worse.
You have 40 hours a week to fill now that you are no longer working and you aren’t going to just spend it sitting at home watching daytime soap operas. You are going to travel, go to shows, go out to eat. All of these things are great but of course aren’t free so you must plan for them.
Your health is going to drain your retirement fund as well. We’ve all seen horror stories of hospital bills and lack of insurance. Planning for how much you will need down the road isn’t straightforward because we don’t have a crystal ball. There are still ways to plan around the uncertainty which I’ll show you later on.
Enough with the rambling though, here’s how you can figure out what your magic number is.
The 4% Rule
The 4% rule is probably the most well known and easiest rule to use. What it states is that you can withdraw 4% of your retirement account per year and statistically speaking it will last you about 30 years. So, if you have a balance of $500,000 you can withdraw $20,000 per year. This rule was developed and studied for decades by people a lot smarter than me and it has proven to work for millions.
The first thing you must know is how much you spend or plan on spending per year in retirement. I’d highly advise against guessing on this but rather take the time to actually add up everything you spent last year. Again, this doesn’t take into account your income, just expenses. Here are some ideas of things you need to add.
- Housing
- Food
- Transportation
- Health Care
- Shopping
- Taxes and Insurance
- Travel
If you want to get even more specific, try to estimate where you are going to be in the future. When I’m 65, I don’t plan on having a home mortgage or a car payment but I do plan on traveling a lot more. Once you get this number just insert it into this formula:
If you think you’ll need $50,000 a year, then take it divided by .04 to get $1,250,000. Now don’t freak out. I know it sounds like a lot but you’re smart and starting early. Later in this article, I’ll show you exactly how much you need to save per month to hit this goal.
The Good and Bad of the 4% Rule
If you’re looking for simple then the 4% rule is about as good as it gets. Simple sounds like a negative to some people, but I believe it puts into perspective how soon you need to start saving for retirement if you want to keep your lifestyle. Also, as stated above, you don’t have a crystal ball and some of your estimates will be off but you can always adjust down the road.
The item that gets criticized the most is the cost of healthcare. Who knows what is going to happen to us in our lifetime so how can you possibly estimate healthcare? Because of this, I think it is a good idea to take whatever you estimate for yearly cost and increase it by 50% or even double it just to make sure you are covered. Because again, you don’t want to be that person returning to the workforce.
Lastly, the 4% rule assumes that you will ONLY withdraw 4% per year. If you have one year where you splurge and spend say 10% it can cut your nest egg down too quickly and may cause you to run out of money. This is the worst case scenario. To shield against running out of money, take your yearly spending divided by 3% (this changes it to the 3% Rule). Airing on the conservative side is always better than cutting it too close.
Taxes and Other Income
When you finally reach the point of retirement, chances are you will still have income. Social security, company pensions, or even rental incomes will be giving you some sort of income which is going to be taxed. To keep this simple, I have excluded all of these incomes from the 4% rule above. Just know that if you pull $50,000 per year out of a traditional 401(k) you will pay over $8,000 in taxes based on current tax rates.
You are going to be taxed until the day you die. It sounds harsh, but that is the world we live in. Even if you are retired, Uncle Sam will find a way to come after you. The size of the dent your taxes will make just depends on what state you live in.
All states are different but quite a few of them tax the main two incomes after someone leaves their job; their 401(k) and social security. This tax rate will depend on a couple things but most importantly how much taxable income you have. Figuring all of your taxable income is out of the scope of this blog post so let’s keep it simple.
How Much Do You Need To Save Now?
It’s time to break down how to get to that humongous number of $1,250,000. Like I said earlier, this may seem overwhelming but I have made it extremely simple by building a calculator located on the site. All you have to do is enter four pieces of information: savings goal, current savings balance, interest rate, and the number of years. Here’s how it came out:
From this, you can see that in order to reach the $1.25M retirement goal you need to be saving $419.17 per month. Think you can do it? Think you can build this into your monthly budget? The good thing about this is some of you are contributing close to, if not more than, this already through your companies 401(k) program. On the other side of things, some people, unfortunately, have a larger bar tab than this per month or are making a car payment that is double this. You can do it. Bottom line is you can do it.
Check out the calculator here. Play around with it and see what happens if you decrease the number of years you have to save or get a lower interest rate. The effects can be drastic.
Wrapping it Up
Consistency, patience, and self-control are the keys to building that retirement account that seems so out of reach today. Chances are high that we won’t be able to predict the future in our lifetime so do what you can today to prepare as best you can.
Next week I’ll show you how to make that $420 come out of your account immediately so you won’t even know it’s gone. After a couple months you won’t even know it’s happening and the out-of-sight, out-of-mind will come into play.
If you happened to miss any of the previous articles you can check them out here by following the links below.