How are you supposed to know how much money you need to retire comfortably? In this article, we’ll explore the answer to that very important question.
Most experts will tell you that you need 80% of your final pre-retirement salary to live on each year, but there are two problems with that:
(1) How do you know what that amount will be?
(2) How do you know how much money to save to get there?
The amount of money you need to retire depends on the amount of money you plan to live on each year you’re retired. That amount will vary from person to person, but the goal should be to live on 8% of it. If you can live on 8% each year, you may very well never run out of money.
This is important for two reasons:
(1) You don’t want to run out of money during retirement, obviously.
(2) You want to leave your money to others, hopefully.
If those two things are important to you–as they are to me–how might we see how it’s accomplished?
Remember, it’s difficult to project what your pre-retirement salary will be, let alone what 80% of it will be. Instead, let’s use real numbers today to figure out what we will actually need at retirement.
Say you would like to live like you do today when you retire, and today you currently live on $40,000 a year (you can use any figures you’d like); how would you figure the amount needed to do that?
First, we want to figure out what $40,000 would be in 30 to 40 years (or whenever we plan to retire). We need to figure the cost of living during that period.
This will require a little bit of math, but stay with me.
The cost of living–also known as inflation–has averaged about 4% per year (on average).
Let’s use a “compound interest” formula to figure this:
A = P(1 + r)^t
- Where A is the final amount.
- P is the principal amount ($40,000).
- r is the inflation rate (4%).
- And t is the amount of time (30 years).
The calculation would go as follows:
- 40,000(1 + .04)^30
$130,000 is $40,000 (30 years from now).
Obviously, if you make more or less, you will need to adjust those numbers–but you get the idea.
Or, if you want to live more comfortably than you do today, you can figure those numbers, too–just use the formula above with those numbers.
To make things easy, let’s just assume we want to live as if we were making $40,000 a year–but 30 years from now.
Live on 8%
If $130,000 is $40,000 (30 years from now), how much will we need at retirement, in order for $130,000 to be 8% of that?
We can figure that using simple division:
130,000/.08 = 1,625,000
So, we need $1.6M at retirement?
Now, we need to figure out how much we need to save per month in order to have $1.6M at retirement.
Here we can use an investment calculator to help us with this.
Historically, the 30 year return of the stock market has been about 12%. So, if we invest our money properly–matching or beating the stock market–we can assume a 12% return on our investment.
Related: How to Get a Good Return Investing
But where do we start?
If we pick a number we are comfortable investing, we can plug that amount into the calculator to see where we end up.
Let’s say we try $100 a month over 30 years at 12% returns.
If we use those figures, we will end up with $350,000–which is not enough.
If we double that, we can expect double the amount–about $700,000–still not enough.
If we double that, we are starting to get close.
Finally, if we save $460 or more a month for 30 years at 12% returns, we will reach our goal of $1.6M.
Obviously, if we save more (or save longer), we will have even more than that.
In fact–if you make $40,000 a year, $460 a month is about 14% of your income–which is close to the recommended amount of 15%. Perhaps that’s why most experts recommend saving 15% of your income towards retirement.
Regardless, if you want to see the numbers yourself, the math above will help you do that.
The reason 8% is important is because of what kind of returns we should expect. If we invest properly–investing in mutual funds that give us 12% returns (or more)–that allows us to break even after inflation (4% on average).
In theory, it means we might never touch the actual money that has been saved–we would only be living on 8% of the interest earned. That 8% continues to pay us through retirement, and we continue to live on that amount each year.
The money stays invested–the same way it it has been all these years–and it continues to average the same returns (12% on average).
We essentially never run out of money because we are 8% above inflation and choose to live on that amount.
Basically, our nest-egg makes 12%, we live on 8%, and lose 4% due to inflation, leaving our nest-egg untouched.
Next year, we do it all over again–again and again–all throughout retirement.
Sure you don’t have to live on 8%–you can live on more, or less, or whatever you want–it’s your money!
This is just one way of doing it–and a good one, I think–if you want to leave a legacy once you pass.
If you don’t want to leave an inheritance, you don’t have to. But this is how I’d do it, if it were me–which is what I plan to do–God willing.