There's no magical, one-size-fits-all way to calculate a retirement number. For example, I've heard many experts say that a good estimator is to multiply your current income by 25, or some similar method.
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While these may be good for vague, ballpark estimates, if you want a more accurate picture of how much you'll need in savings for a comfortable retirement, here are five steps that can help you calculate your own retirement number and figure out how much you should be saving each month in order to get there.
- Determine how much income you'll need after you retire.
- Estimate your other income sources
- Calculate your income need from your retirement savings
- Determine how much you'll need in savings
- Adjust for inflation
Let's look at these steps in more detail, along with an example:
Determine how much income you'll need after you retire
The average retiree needs about 80% of their pre-retirement income in order to maintain the same standard of living after they retire. In other words, if you and your spouse are currently earning $100,000, you'll need about $80,000 per year after you retire.
Admittedly, this isn't perfect, and you should adjust this percentage up or down to better fit your goals. For example, if you've always been a super-saver and plan to downsize your home and lifestyle after retirement, you could probably live comfortably with significantly less than 80% of your income. On the other hand, if you plan to travel more, spoil your grandkids, and pursue expensive hobbies, you may want to aim for more than 80%.
Estimate your other income sources
The good news is that your retirement savings are likely not your only source of income in retirement. Most Americans over the age of 62 are eligible for Social Security benefits, and many people have pensions from current or former employment.
The Social Security benefit formula is rather complex, and it's also impossible to know how much you'll earn between now and when you retire. However, you can get a good idea of what to expect if you create an account at www.ssa.gov and view your most recent Social Security statement.
If you have a pension plan, you can usually log on to your plan's online portal and get an estimate of how much income you can expect in retirement.
Calculate how much you'll need from your retirement savings
Here's the easy step. To calculate how much annual income you'll need to generate from your retirement savings, simply subtract your other sources of retirement income from your overall income need you estimated in the first step. In other words, if you estimate you'll need $80,000 after retirement and between Social Security and pensions, you and your spouse expect $35,000 per year, this implies that you'll need $45,000 from savings.
Determine how much you'll need in savings
The 4% rule of retirement essentially says that you can withdraw 4% of your savings during your first year of retirement, and then give yourself cost-of-living adjustments in subsequent years, without having to worry about running out of money. While this rule certainly has its shortcomings, it's a good tool to use to estimate your savings goal.
To apply the rule, simply take your income need from savings that you calculated in the previous step, and multiply it by 25. If you determined that you'll need $45,000 in annual income from savings, this translates to a target nest egg of $1,125,000.
Adjust for inflation
We're not done just yet. The savings target you just calculated is in 2017 dollars. A million dollars in 2017 is not going to have the same purchasing power when you retire, and this is especially true if you're still a decade or more away from retirement.
While there's no way to know what inflation is going to be each year in the future, a reasonable expectation, based on historical data, is a long-term inflation rate of around 3% per year.
To adjust your savings goal for inflation using the 3% estimate, take 1.03 and raise it to the power of how many years you have left until retirement (don't worry, I'll make this easier in a second). This is your "inflation multiplier." To save you the math, here are some inflation multipliers based on how many years you have left until retirement.
To illustrate the process, let's take a look at an example.
Let's say that you earn $75,000 per year, and that you estimate that you'll need 80% of your income after retirement, or $60,000 per year. You're 45 years old and plan to retire at 65.
We'll say that you expect $20,000 per year from Social Security, and that you have a pension from an old job that should pay you about $10,000 per year. So, you'll need $30,000 per year from your savings.
Applying the 4% rule shows that you should aim for $750,000 in savings, in today's dollars. Since you plan to retire in 20 years, multiply this amount by 1.81 to compensate for inflation. This implies that in 20 years, you should aim to have a retirement savings balance of approximately $1.36 million to produce the quality of life in retirement that you want.
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