How much do I need to save for retirement?
This is one of the biggest unknowns that we all face. How much do I need? $1,000,000 or $2,000,000 or $5,000,000? The answer is as complicated as how much you need to buy a house or car: it depends on what kind of retirement income you will generate.
The number is further complicated by the fact that future retirees who make less than $60,000 will be able to replace a higher amount of their income with Social Security. The truth is, using some kind of planning software will help a lot. I’d love to help you with that, but if you simply want a quick number, here is my quick and easy method.
Take 10% from your current income
You will not have payroll taxes and your income taxes will probably be significantly lower. So reducing your income by only 10% is quite conservative.
reduce by the percentage you are saving for retirement
If you are contributing 5% of your salary to a 401k plan, that means that you do not need to replace that for living expenses. So in this case, your adjusted income would be 85% of your current income.
compute your post social security retirement needs
Find your payout for Social Security at age 70. This will give you your maximum payout. Subtract this amount from your adjusted income (reduced by 10% for Social Security and taxes and your retirement plan savings rate).
choose your multiplier = 100 / expected real return
What is your expected real return? This is a tough one and is the real culprit of uncertainty in your retirement plan. First of all, your real return is the market return minus the rate of inflation. So if your portfolio has an average return of 6% and inflation is 2%, your real return is 4%. 4% is a reasonable place to begin. If we use 4%, then your multiplier would be 25 (100/4). So if your income need after Social Security is $25,000, you would need $625,000 saved (25,000 x 25). Assuming a real return of more than 5% is probably risky. If you’d like to be more conservative, then you could assume a real return of 2-3%. So in summary, depending on your expected real return, you will multiply your income need(after Social Security) by at least 20 (I would say 21) and could go as high as 30 if you would like to be more conservative about the market return.
60,000 x 85%(adjusted income) - $30,000 (Social Security) x 25(multiplier) = $525,000 for retirement at age 70
Pre-Social Security income Needs
How much income will you need before Social Security? How many years? Let’s put these figures into a Net Present Value calculation. We should assume a very low return for safety, but calculating this way assumes that you will use up the money and end with zero. Remember, we have already computed the amount you will need once Social Security begins. We will use a conservative value for return, which means you will probably have funds left if you invest wisely. You could also purchase a fixed period annuity to cover that period.