Are you ready to retire? For millions of Americans, the answer to that question is, "I'm not sure." In order to retire with confidence, the key piece of the puzzle is knowing that your financial needs will be met for the rest of your life. With that in mind, here's a quick guide that can help you definitively know if you're ready to retire with confidence, or if you'd be better off waiting a few years.
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How much income will you need in retirement?
Many people have a retirement "number" -- that is, the amount of money they think they need to save for a comfortable retirement. Lots of these people say $1 million, $2 million, or another round dollar amount. However, studies have shown that most people are guessing when they say these figures.
Here's the secret: The amount of money in your savings is important, but shouldn't be your primary concern. Instead, you should ask yourself if you'll have enough income in retirement.
Think of it this way: If you're earning $72,000 per year ($6,000 per month), and you expect to receive $2,000 per month from Social Security, $2,500 per month from a pension, and $1,500 from an inflation-indexed annuity after you retire, your income should support your lifestyle just fine -- your savings balance doesn't matter too much.
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On the other hand, if your only expected source of retirement income is Social Security, it's not likely to be enough to support the kind of lifestyle you want in retirement all by itself. In this case, you'll need adequate savings to create income. According to most experts, you should plan to need about 80% of your pre-retirement income after you retire, to sustain your quality of life. This may turn out to be higher or lower for you, depending on your situation, but it's a good estimate to use when planning.
Make sense? With this concept in mind, here's how to tell if you're ready to retire with confidence.
How much Social Security will you get?
The first thing to consider is how much you can expect from Social Security.
Now, Social Security retirement benefits are designed to replace approximately 40% of the average American's pre-retirement income, but this varies considerably from person to person. Your Social Security benefits depend on your income throughout your career, how many years you worked, the age you decide to claim benefits, and whether your spouse is entitled to a benefit on your work record or their own.
The method for calculating a Social Security benefit is quite complex, and if you're working, it's impossible to know yours for sure before you actually retire. Fortunately, the Social Security Administration can provide you (and your spouse) with a good estimate. If you haven't done so already, create an account at www.ssa.gov and take a look at your most recent Social Security statement. You'll find an estimate of your full retirement benefit, as well as what effect claiming as early as possible (age 62) or as late as possible (age 70) may have, and some other valuable information, as you can see from this screenshot of my Social Security statement.
Image source: Social Security Administration.
Other sources of income
Next, consider any other sources of steady retirement income you may have. If you are entitled to a pension from your current or former employer, you can probably obtain an estimate of how much to expect.
Also, consider any annuities you may have purchased, or any other sources of income you expect. Many Americans' only steady retirement income source is Social Security, so you may not have anything in this category.
The "4% rule" of retirement
After you've added up all of your expected sources of income in retirement, then is the time to worry about your savings.
While it's admittedly not perfect, the "4% rule" of retirement is a good place to start. You can read a great discussion about the rule and its shortcomings here, but simply put, the rule says that you can expect to withdraw 4% of your savings during your first year of retirement and give yourself cost-of-living increases in subsequent years, without fear of running out of money during your lifetime.
In other words, if you have $1 million in savings, this rule says you can safely withdraw $40,000 during your first year of retirement. If the inflation rate is 2% that year, you can increase your withdrawals by this amount for the following year, to $40,800.
Adding it up: How much savings do you need?
Using the admittedly imperfect 4% rule, here are the steps to get a good idea of your retirement number:
- First, figure out how much income you'll need. Multiply your current annual salary by 80% (0.80).
- Divide this amount by 12 to figure out your monthly retirement income need.
- Subtract your estimated Social Security benefits, as well as any pensions or other income sources. This is the amount of monthly income you'll need to produce from savings.
- To apply the 4% rule, multiply this amount by 12, and again by 25. This is your target retirement savings number.
A good starting point
This is a good way to get an estimate of your retirement savings need, and it's certainly better than guessing an arbitrary number like $1 million. However, keep in mind that this isn't perfect, and you may want to adjust this to match your lifestyle, risk tolerance, and desired quality of life in retirement.
For example, if you want to play it safe, you may only want to plan on withdrawing 3% of your retirement savings per year, not 4%. Or, if you plan to travel a lot in retirement or pursue other costly hobbies, you may want to anticipate an income need greater than 80% of your current salary.
The point here is to give you a method to generate a concrete number to aim for that is customized to your life, so that if you reach it, you'll know where your income will come from after you retire and how much you can expect, so that you can retire with confidence.
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