Doing the Math to Calculate Your Retirement Savings Goal

Dear New Frugal You,

I'll turn 50 this year. So I'm beginning to think about retirement. My question is a simple one, but no one seems to be able to give me a clear answer: How much money will I need to save for my retirement? Is there some way to calculate it?

- Zach

Dear Zach,

You're right. By age 50 you definitely should have a retirement plan in place, which isn't always easy, especially in the current environment. Let's see if we can't set up a framework to help you determine how much you'll need to save for a comfortable retirement.

We'll begin with a caution: There is some math involved. If all you want to do is just plug in numbers into a retirement calculator, that's easy. But I'd encourage you to continue reading so you understand how the numbers can affect your results.

Our first task is to estimate how much income you'll want. Then we'll figure out how much savings you'll need to earn that amount of income.

Estimating your income needs in retirement isn't an exact science. You can find experts suggesting between 50% and 100% of your pre-retirement income. Part of the huge variance is due to the variety of retirement lifestyles. Some retirees are content to stay home and tend their gardens. Others take off on that long-postponed world tour.

Take your best guess as to how your desired retirement lifestyle will affect your income needs. Tend to err on the high side.

We'll make up some numbers to work with. Suppose that your current income is $75,000 per year. And you think you'll need about 65% of your current income to enjoy retirement. Multiply your current income by that percentage ($75,000 X .65 = $48,750). To make the illustration easier, let's round up to $50,000.

So that means that you'd need $50,000 per year in retirement. But, that's in today's dollars. What about inflation? Even minor inflation can raise prices significantly over time.

You can use a simple savings calculator to adjust our income target for inflation. In this case we'll enter $50,000 as our starting amount with no additional monthly deposits. Let's choose 3% for "annual interest," which will represent inflation. And 20 years until we want to retire. The calculation works out to $91,037. That's how much inflation-adjusted income we'll need.

Next we'll need to estimate how much of that $91,000 (yes, I've rounded again) will be provided by Social Security. Not an easy question. The trustees of Social Security say that the trust fund will be empty by 2033. That doesn't mean the system will be out of money -- tomorrow's workers will still be paying in -- but it does mean that today's payout levels are questionable. Either benefits will have to be cut or taxes raised -- iffy propositions in today's political world. So you may decide to only include a portion of SS promised benefits in your calculation.

A call to Social Security (800-772-1213) or a visit to its website will get you a form to find out your expected benefits. We'll use the 2013 maximum benefit of $2,533 per month or $30,400 per year.

Next we'll subtract any private pensions that you may have earned. You'll probably need to contact the HR department of your employers (past and present) to find out what you can expect to receive. We'll assume that you'll get $1,800 a month or $21,600 per year.

We now have the three big pieces to our puzzle: how much income we'll need, how much Social Security and private pensions will provide. Subtract the Social Security and private pension from your total. In our case that leaves ($91,000 minus $30,400 minus $21,600 = $39,000).

So we'll need to save up enough money in our IRAs, 401(k)s and savings to earn us $39,000 per year.

We have one last question to answer. How much do we need to save to give us that $39,000 per year? Again you'll get different estimates as to how much income you can take each year without eroding principal. We'll choose a medium estimate of 4% per year.

Dividing our annual income desired by 4% tells us that we'll need to save $975,000.

Now that you've survived the math (which wasn't really all that hard), let's look at some of the assumptions.

I know that experts will say that this is a simplified version. They're right. For one thing, we didn't adjust Social Security benefits for inflation. We could have easily increased them just like we did our income requirements. And, it's also possible that our pension benefits will be adjusted for inflation.

This estimate was meant to be simple. In part because we have some big assumptions that go into any retirement projection. Inflation rates for decades. Investment earning rates. The future of Social Security. Minor changes in any of those rates extended decades into the future make a huge difference. So trying to be overly accurate just isn't possible. This method is fine for getting you in the ballpark, though it won't guide you to your individual seat.

The key thing is to begin saving now. No matter how accurate or inaccurate your estimates are, you'll save more if you start sooner. So starting to save now is always the right answer.

You can recalculate as you update your assumptions over the years. You'll have more info to go on. Your calcuation will become more accurate and as you near retirement you can refine your expectations.

But whether you're 25 or 50, the time to start saving for retirement is now!