Many factors need to be taken into account when deciding how much you need to have saved for retirement. Solving for this number is a significant step on your path to retirement, and the task can be as complex or as simple as you want it to be.
This post is lengthy but includes everything from inflation to taxes and even includes a section of considerations for early retirees. You can be as detailed as you want when estimating your number and I have provided examples throughout that help break down the math.
Because of the post length, if you don’t want to read straight through I have included this index to make navigation easier.
Starting Simple: Four Percent Rule
The first step of retirement planning is to find out how much you will need on a yearly basis during retirement, and then the math just flows from there.
You will have to consider your situation and goals but take a look at your current budget and adjust these numbers for retired you. The goal is to decide what you will be comfortable living with for an annual salary. Keep in mind that in a traditional retirement you will likely not have a mortgage and will not be saving for retirement. Once you have your retirement income, you can estimate how much you need to save to achieve this cash flow goal
For a quick estimation of your retirement account needs, you will need to save 25 times your yearly retirement spending to retire. This balance will enable you to draw four percent from the account on a yearly basis and have a low probability of running out of money in retirement. This estimation is known as the four percent rule.
Example: Four Percent Rule
You need $50,000 every year in retirement. Using the four percent rule, you should plan to save:
Savings Goal: Annual Amount Needed x 25
Savings Goal: $50,000 x 25
Savings Goal: $1,250,000
At this point, you will be able to withdraw four percent of your $1,250,000 every year to meet your annual expenses. During this time your account will ideally continue to grow with the financial markets at or above this four percent rate limiting your risk of running out of money during retirement and maintaining your purchasing power.
While the four percent rule is the standard estimation used for retirement calculations and has been tested by academic papers, critics have chastised the rule for being too conservative.
Attackers on the four percent rule claim that retirees should be able to pull more than four percent and still be safe during retirement. While this may be true, I prefer to stay conservative and would rather have more money in the account than I need opposed to less money than I need.
There are other factors to consider that can affect how the four percent rule applies to your retirement plans starting with any other retirement income.
Other Retirement Income
The four percent rule works well if your only source of income comes from your retirement account. However, if you have other sources of income, then you can reduce the amount withdrawn from your retirement account.
For a traditional retirement, social security income is one of the largest sources of other retirement income.
Using the same example as before, we can assume that you need an income of $50,000 per year in retirement. If $20,000 of this will come from social security, then you only need $30,000 from your retirement accounts. $30,000 x 25 gives a retirement account total of $750,000. The new balance is half a million dollars lower than the previously required amount.
Of course, you should take caution with any retirement plan that includes social security as a source of income. Politicians have talked about modifying or dropping social security for years, and the weight of the national debt doesn’t help the fight against these decisions.
Depending on how far away you are from retirement, planning on the more conservative side is a safer bet. Any decision made to cut or dismantle social security will likely not affect those close to retirement. Since I am many years away from a social security check, I do not include social security as part of my income during retirement. If I do receive a social security check one day, it will be a bonus, but will not be a factor in whether I can keep the lights on.
Like social security, a pension plan provides a revenue stream during retirement. Few pension plans continue to exist and even if you have a pension you have likely been given the opportunity for your employer to buy you out of their pension obligation. In this scenario, the company will write a check for you to invest in your retirement account now in exchange for the company not having to pay you a check in retirement.
Whether or not the buy out is a good deal is a complicated issue because there is no standard calculation that all companies use to determine what the value of your pension is worth.
Also, like social security, counterparty risk is the main risk for pension payments. If the company poorly invests its pension account, underfunds the account, or has financial trouble, your pension payments could be at risk. Do your homework on the company or municipality offering the pension to determine whether they have a strong capacity to pay. If this is not the case, then taking a buy out may be a good option.
You can solve for how much you need to save for retirement with pension payments the same way you would determine retirement account balances that assume social security payments. Deduct the pension payments from your annual retirement spending needs and then multiply this amount by 25 for the new savings goal.
Inheritances are a complicated matter because estimating the likelihood or timing of the payout is difficult and relying on someone to pass away for your to retire doesn’t meet my definition of taking control of your finances or being financially independent. In fact, this is one of the most dependent situations you can have.
If planning for an inheritance, you will include any money received in the total retirement account value. If you initially expected to save $800,000 for retirement but will receive a $200,000 inheritance, then your new goal is $600,000.
There are many ways to structure wills and trusts that can provide more guarantees of future inheritances or money transfer. You and the benefactor should consult with an estate planning attorney and consider setting up a trust to make this transfer process as smooth as possible.
How you invest your retirement account will affect your tax exposure when retirement arrives. If you invest in traditional retirement accounts like a 401k or IRA, then you will pay taxes on any withdraws. Ideally, your income needs will be lower during retirement than before retirement so your tax rate should be lower. In this case, the amount you estimate that you need on a yearly basis should include tax payments.
Example: Tax Adjusted Retirement Needs
If you plan to pay 15% in taxes during retirement, you need $50,000 to pay your bills plus taxes.
Pretax income: Spending Amount / (1 – tax rate)
Pretax Income: $50,000 / (1-.15)
Pretax Income: $58,823
This is the annual total amount you need in retirement to pay your bills and taxes.
Using the four percent rule, $58,823 x 25 gives a retirement account of $1,470,575.
When investing in different types of retirement accounts, your retirement income tax will depend on which account you withdraw from and when you withdraw the money.
If you have 50% of your retirement account in a Roth 401k and the other 50% invested in a traditional IRA, then only half of your withdrawn amount will be taxed. The Roth 401k was already taxed and can now be spent tax-free. You can find a more detailed breakdown of different retirement accounts here.
Example: Two Retirement Accounts, Different Tax Implications
You have $800,000 invested in an IRA and $750,000 invested in a Roth 401k. Assuming a 4% withdrawal rate, you will pull $32,000 from your IRA and $30,000 from your Roth 401k. Assuming you pay 15% in taxes, but only on the $32,000 IRA, you will have a tax bill of $4,800. After tax, you’ll take home $57,200.
IRA withdraw: $800,000 x .04 = $32,000
Roth 401k withdraw: $750,000 x .04 = $30,000
Total Pretax Income = $62,000
Taxes = .15 x 32,000 = -$4,800
Post Tax Income: $62,000 – $4,800 = $57,200
You can do this same exercise for a variety of retirement account combinations. A spreadsheet makes solving these equations much easier.
Depending on the total amount of your total retirement income, you may be taxed on your social security income as well. As of 2017, the cutoff was $25,000 for individuals or $32,000 for filing jointly. If you breached these thresholds, then you would have to pay taxes on up to 85% of your social security income. IRS Source for more information.
Inflation During Retirement
Inflation eats away at the purchasing power of your nominal returns. Nominal returns are the returns before inflation adjustments or the amount your account value actually increased. If your account earns an 8% nominal return, but the US dollar dropped in value by 3%, also known as 3% inflation, then your real return is 5%.
The four percent rule already accounts for inflation. Any real return of four percent or more will allow you to withdraw from the account without losing any account value from a real purchasing power standpoint. Inflation is measured using the Consumer Price Index or CPI, and while it is currently very low, it historically averages one percent.
Since inflation is almost nonexistent, your total savings amount will be affected very little. However, if inflation were to increase, you would need to consider what your adjusted yearly spending would be in retirement. You may be able to live on $50,000 now, but in 20 years that same $50,000 may only be able to purchase a fraction of the amount you need to live.
Example: Adjusting Retirement Income by Inflation
Given current spending needs of $50,000, you would need $61,009 to have the same purchasing power in twenty years. To solve for this, I conservatively assumed everything would become 1% more expensive every year. So $50,000 worth of expenses today grown at 1% per year is $61,010.
Future Value = Present Value x (1+Rate) ^ Time
Future Expenses = 50,000 x (1+.01)^20
Future Expenses = 50,000 x (1.2202)
Future Expenses = $61,010
Amount Needed for Retirement Before Inflation Adjustment: $50,000 x 25 = $1,250,000
New Amount Needed for Retirement: $61,010 x 25 = $1,525,250
Additional Considerations for Early Retirees
If you plan to retire early, the conversation about retirement takes a shift. Social security is of little importance to you especially if you are planning a very early retirement and inflation impact during accumulation is almost zero.
For the purposes of this section, I am speaking to early retirees of 40 and under because the considerations are much more extreme than for someone retiring early at 60.
Other Retirement Income
Early retirees are not typical retirees and therefore do not have some of the benefits of traditional retirees. Don’t worry though, the whole not working until your 65 thing is a great benefit.
For one, social security will not be a source of income until 65; this means that you will have to create income on your own for 25+ years before the government mails your first social security check. If you can generate income from retirement accounts for 25 years with the four percent rule, then there is no reason it cannot continue into retirement.
The four percent rule works the same for early retirees but has an added importance because your retirement income is likely coming directly from your retirement accounts, so there are no adjustments for social security or, most likely, inheritance.
A benefit for you as an early retiree is that you are still able to work if you needed to, so risk during the beginning of retirement, the riskiest time, is minimized. You can turn a hobby into a side gig for extra cash, or completely retire and sleep soundly knowing that if ever you have to go back to work for a year or two you are in good health to do so. That being said, if you use the four percent rule, the probability of you needing to supplement your income is very low.
Since the four percent rule accounts for inflation during retirement, when your retirement day comes, inflation will no longer be an issue. In fact, because your account balance is accumulating so fast, inflation will likely not be an issue at all.
As you can see in the example below, the inflation impact is less than half when compounding inflation over ten years opposed to 20. You will only need to multiply your annual expenses by 1.1046 opposed to 1.2202.
Example: Inflation Impact on Early Retirement
I conservatively assumed everything would become 1% more expensive every year. So $50,000 worth of expenses today grown at 1% per year for ten years is $55,230.
Future Value = Present Value x (1+Rate) ^ Time
Future Expenses = 50,000 x (1+.01)^10
Future Expenses = 50,000 x (1.1046)
Future Expenses = $55,230
Amount Needed for Retirement Before Inflation: $50,000 x 25 = $1,250,000
New Amount Needed for Retirement: $55,230 x 25 = $1,380,750
Taxes will play a major part in your early retirement planning because to accumulate the amount of money needed to retire quickly you will likely be contributing more to retirement after maxing out tax-sheltered retirement accounts.
Your retirement income will likely include distributions from brokerage accounts where you will pay capital gains taxes. Also, traditional IRA and 401k contributions will not be able to be withdrawn until traditional retirement age, unless you take a 10% penalty.
While taxes make early retirement seem complicated, in reality, it just means that you will have to do some extra planning and prioritizing. You will need to determine the order of accounts you contribute to and the order of the accounts you withdraw from.
Currently, you can transfer money from a traditional IRA to a Roth IRA and not take the 10% penalty as long as you do not touch the money for five years. Simple enough, every year you can transfer money you will need in five years to your Roth IRA. Given this strategy, you only need five years of savings in a Roth IRA or brokerage on the day you retire. Then you can withdraw this amount without penalty until you can access your Roth conversions in five years. This is known as a Roth Conversion Ladder.
A Roth Conversion Ladder is a great plan and a considerable asset for early retirees, however, I always have problems trusting the government and tax rates for an extended period. Laws can change and drastically impact retirement plans, especially if it means more revenue for the government.
If you are considering a Roth conversion ladder, please read through my article on gambling on future tax rates first. It is my comparison of Roth vs. traditional retirement accounts for early retirees.
Conclusion: Your Number
I have laid out the basics of determining your retirement number. Be thorough and honest when you determine your budget and yearly spending needs.
Do you really need to be able to charter a private jet every quarter? If not, maybe you don’t need a $300,000 annual income. On the other hand, have you ever been able to cut your expenses under $30,000, but are planning to live on $15,000 in retirement?
Don’t set yourself up for failure. Leave a cushion for the unexpected. The four percent rule takes care of most of the investment and inflation concerns. Focus on your post-retirement budget and build a contribution and withdrawal strategy that will play the best with your plans and tax exposure.