UPDATED: April 21, 2022
In retirement, people permanently leave their careers and most or all of their earned income behind. Social Security can fill part of the income gap, but what about the rest?
Let’s take a look at the common methods of figuring out your personal retirement number. How much do you need to retire?
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The Retirement Puzzle Pieces
The optimal retirement savings amount will depend on your expenses, lifestyle, cost of living, tax profile, and other income sources.
If you’re the typical American worker, you will someday draw Social Security benefits. As of December 2019, the average check sent to retirees each month was about $1,500. We don’t know what the future will bring for Social Security, but it is unlikely that this benefit will disappear completely. If you are close to retirement, it’s probably safe to count that money towards your retirement income.
Sources of Income
Some people will have various forms of income that are not tied to fluctuations in financial markets. For example, they might own property that’s rented out full-time. Renting out a spare room can provide income with minimal effort. A pension or annuity can provide a steady “paycheck” like income.
Expenses in retirement can be different than they were during your working life. You no longer have a commute. You might want to travel. You might eat out more. Whatever your lifestyle, a new retiree should meticulously track expenses the first year of retirement. This could be a precursor to establishing a baseline retirement budget.
Your income could go down or up depending on your retirement plan. It’s important that you understand the tax implications of your various retirement income sources. For example, every dollar that comes out of a traditional IRA is taxable. If the bulk of your investment assets are in a Roth IRA, you’ll never pay taxes on distributions.
The state you retire in could impact your taxes. Some states do not have an income tax (WA, TX and FL, for example) while some have relatively high state income taxes (OR, CA). If your retirement plan is tight, you might consider moving to a tax friendly state with a lower cost of living.
Percentage of Pre-Retirement Income
Experts believe that you need to replace 70-80% of your income. This is the total percentage that you need to meet expenses while maintaining your lifestyle.
While this is a solid baseline, the amount a new retiree will need might be greater than their employment income or less. It all depends on your intended lifestyle. For example, many new retirees front load their travel while in good health. This would bump up retirement expenses in the early years.
Conversely, a new retiree might downsize their home, move out of a metro area, and thus lowering their cost of living. This would reduce expenses and might even add to their retirement portfolio by downsizing their home.
How much you need as a percentage of your employment income, will depend on your lifestyle.
Trouble with this Approach
The problem with the “income replacement” approach is that it is a bit simplistic. Your lifestyle could change after retirement. You also have to take inflation into account. Not only that, but you might decide to work part time for a while, which boosts your income beyond what’s typical for retirees. For those reasons, some experts believe that the 80% rule, and even the 70% and 60%, are not optimal.
Many financial advisors believe that the multiple-of-expenses approach is a better way to calculate your retirement needs. According to this method, you calculate your annual expenses in retirement.
Once you have this number, you’ll want to subtract your expected annual Social Security earnings. Then, you multiply that number by your remaining life expectancy (how many years you expect to be retired). Since it's hard to know exactly how long you are going to be around, many financial experts recommend using 25X your expected annual expenses as a starting point.
Average Retirement Length
According to a study done in 2018, the average American is retired for 18 years. The study assumes that retirement happens at age 63, and the average individual lives until age 81.
You need to ensure that the money you’ve saved up will last that long. If you want to leave a legacy, either through charitable donation or inheritance for heirs, you’ll want to factor that into your retirement plan.
Expenses Change Over Time
Although the average retirement lasts for 18 years, you’ll need more than 18 times your expenses to retire. This is because inflation will reduce the value of your dollars over time, resulting in the need to increase your income.
If you were to run out of money, or were unable to increase your retirement income, it could result in financial stress. Financial planners recommend that you have an effective hedge against inflation built into your retirement savings plan.
The most common way to beat inflation is investing in assets; stocks, real estate, etc., that exceed the annual rate of inflation.
Planning for the Unexpected
No matter how well you plan, there are always going to be unexpected surprises. Perhaps the biggest wildcard for retirees is healthcare expenses. While most people will have Medicare, it doesn’t cover long term care.
In addition, there are co-pays, exclusions, and deductibles, just like any other type of insurance. If you end up in a nursing home, this will be a major expense.
It is important that you have a margin of safety built into your plan to address unexpected expenses.
How Many Times Expenses?
For the vast majority of retirees, experts believe that saving 25x your expenses is sufficient. However, this does not mean 25 times your total expenses. Rather, it’s 25 times the difference between what you’ll need to spend in retirement and the income you’ll get from other sources.
For example, if you are receiving Social Security, you would subtract Social Security benefits from your core expenses, then multiply the remaining number by 25. Expenses change over time, you should run this rough calculation every year to make sure you’re on the right track.
Ideally, the money you have invested or allocated for retirement exceeds your expenses multiplied by 25. The greater the cushion between your retirement assets vs. expenses, the more wiggle room you have to spend or absorb unexpected surprises.
4% Withdrawal Rate
The 4% rule states a retiree could safely withdraw ~4% of their invested assets every year. For example, if a person had a nest egg of $1,000,000, they could take $40,000 per year without running out of money (assuming it is invested correctly).
The 4% figure is based on financial market returns being greater than 4% in the future. The calculation breaks down if there is a prolonged period of lower returns and/or a large stock market decline. A period of out-sized inflation could also derail the 4% rule.
No matter what “formula” you use to plan for retirement, it is important to understand factors unique to your situation, and formulate a plan to be retirement ready.