Many people guess blindly at how much money they'll need in retirement. Though it can be tricky to come up with an accurate number, especially when retirement is many years away, you can use your current income as a guideline for how much to save. While there are always exceptions, generally speaking, you'll be in pretty good shape if you put away 10% to 20% of your income for retirement, but inflation, return on investment, and Social Security should also be part of the equation.
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How much retirement income will you need?
Rather than come up with a magic number -- say, $1 million -- as a retirement savings target, many workers instead will establish goals based on a percentage of replacement income. Say your annual household income is $200,000. You might aim for 80% replacement income, which means you'll need $160,000 per year in retirement.
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Now if you're willing to live a frugal lifestyle, you might get away with less -- say, 70% or even 60% replacement income. On the flip side, if you're hoping to spend your retirement traveling extensively, you may need to aim for 100% replacement income.
The age at which you retire will also play a role in how much savings you'll need to amass. Given that seniors are living longer these days (the Social Security Administration estimates that one in four 65-year-olds will live past 90), the earlier you retire, the more of a strain you'll put on your savings. On the other hand, if you're willing to work into your late 60s or early 70s, you'll stretch your savings considerably by shortening your retirement.
Inflation and return on investment
The money you save for retirement may or may not hold up over time depending on where inflation takes us. While you can't necessarily predict how inflation will erode your purchasing power over time, you can take steps to combat it by investing your money wisely.
Consider this: The average annual inflation rate is 3.22%, but we don't know whether that number will drop or increase over time. What we do know, however, is that putting most of your money into safe investments like savings accounts, money markets, and even bonds will probably cause your savings to fall short in the face of inflation. A better bet is to invest a large chunk of your portfolio in stocks, which have historically delivered considerably higher returns than any of the aforementioned investment options. While stocks are indeed the most risky and volatile, if you have several decades to ride out the market's ups and downs, you're likely to come out ahead in the long run.
To understand the difference between an investment strategy that's likely to outpace inflation or not, take a look at the following table, which shows how much a $400 monthly investment will grow to over time based on varying returns:
TABLE AND CALCULATIONS BY AUTHOR.
You can't help but notice the discrepancy between an 8% average annual return, which you're likely to get with a stock-focused portfolio, and a more conservative approach to investing. That's why when saving for retirement, you'll need to weigh your appetite for risk against the potential for greater returns.
Don't forget Social Security
Though your Social Security benefits won't be enough to cover your senior living costs in their entirety, they can -- and should -- play a role in your retirement savings calculation. Your Social Security benefits are based on your top 35 years of earnings, and if you still have a number of working years ahead of you, predicting what they'll look like can be a bit tricky. You can, however, get a sense of how much Social Security income to expect by estimating your benefits online.
Tying it all together
Now that you have a better sense of what needs to go into your retirement savings calculation, we're making it easy to tie everything together. Just input your data into the following calculator, and you'll see whether you're in good shape for retirement or whether you'll need to work on ramping up your savings efforts:
* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.
Keep in mind, however, that if retirement is still many years away, you'll need to revisit this calculation periodically to see whether you're still on track savings-wise. If your financial circumstances change, or if you find that your investments aren't performing as well as expected, you may need to make adjustments to meet your ultimate savings target.
Either way, the fact that you're thinking about retirement means you're being smart about your future. Keep saving, and there's a good chance you'll end up right where you need to be.
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