How Much Money Do I Need to Save For Retirement?

Calculating How Much Money You Need for Retirement

Every so often I receive questions from readers. I try to answer them all directly, but occasionally a question comes up that is very broad and is one that more people are thinking about but not asking. Everybody wants to know how much they should be saving and how large their account should be once they reach retirement, so I wanted to tackle that question for everyone today.

When it comes down to it there are two methods to help guide you. Some basic rules of thumb that anyone can quickly use to get an estimate and then the process of creating a detailed estimate of retirement expenses and income.

1. Retirement Rules of Thumb

The most common method is simply by using one of the general rules of thumb about retirement income. For years people have been told that you need to generate 75-80% of your pre-retirement income during retirement to maintain your current lifestyle. This is a fine place to start, but there are simply too many problems with this method.

First, we can’t predict the future. We can make some assumptions as to why we will need less income during retirement such as not having a mortgage payment or no longer commute to work, but nothing is certain Epecially if you have a number of years yet before retirement. Another huge factor is health. While you may not have a mortgage payment during retirement you could find that you replace that with high insurance premiums or medical care that wasn’t expected.

2. Creating a Detailed Estimate

A better way to determine how much you should save up for retirement would be to create a detailed estimate based on your specific situation. This means sitting down and taking a look at exactly what expenses you will or won’t have in retirement, what sources of income you will gain or lose, and any lifestyle changes you may have.

Some people will still carry a mortgage while others won’t. Some people may choose to buy a second home or move to a new location in retirement. And depending on what you do during retirement will have a huge impact on your income needs. Maybe you want to travel overseas frequently or maybe you want to join that private golf club you’ve always dreamed of, or maybe you plan on starting a business. You may find you can live comfortably on 25% of your pre-retirement income or you may find you need 150% of that income to reach your goals. Your plans will ultimately dictate how much money you need.

The problem with this method is that this really works best for those who are approaching retirement within maybe the next 5 to 10 years at the most. Beyond that it is difficult to get a real grasp on your financial needs because your situation may still change, tax laws are sure to change, and we obviously have no idea what the state of the economy will be a few decades from now. For those of us in our 20s, 30s, or even 40s, we have to rely on a lot of assumptions for the most part. We really don’t know where our careers might take us, how our income grow, and what our plans are 30 years down the road. Even if we can develop a detailed retirement income and expense plan there’s a good chance it will be completely wrong in thirty years. And nobody wants to retire broke and unhappy.

What The Experts Say

A relatively new study done by a few experts was published in the Journal of Financial Planning to tackle this exact topic. The study aims to address the following:

  1. The annual cash flow needed in retirement
  2. The capital needed to generate this lifetime retirement cash flow
  3. The annual savings needed to build the capital that will provide the retirement cash flow

An interesting note as to why this study is a bit different can be summed up with this:

We used a more sophisticated approach by using the retirement ratio of 80 percent based on pre-retirement net income as defined as gross income less retirement savings. We used net income because someone who saves for retirement has reduced their pre-retirement living expenses and, for most, it typically follows that they also reduce their post-retirement expenses. For individuals who are saving a lot, this can be significant. Lower retirement expenses means less needed capital. You could say the more one saves, the less one needs to save.

In the past the assumption was simply based on gross income. If you earned $50,000 just before retirement then you need to have $40,000 coming in during retirement. This study factors in savings because if you are saving money each year for retirement, once in retirement you won’t be saving and instead withdrawing so that shouldn’t count towards your required income. For example, let’s say you make $50,000 a year and you are putting $6,000 into your 401(k) each year. Instead of just taking 80% of $50,000 you would take 80% of $44,000 ($50,000 – $6,000), or therefore  a retirement income of $35,200.

Capital Required to Generate Income

While it is fine to make estimates about how much money you need in retirement, whether it is based off 75%, 80%, 120% of your income, the other big question people have is how much money does it take to generate that stream of income? When I meet with clients they are often quite distressed. They hear things in the media about how they should have over a million dollars saved up and with $150,000 in their account and 5 years until retirement they think it is the end of the world.

The same study talks about how to estimate how much capital will be required to generate this stream of income. It goes into detail using mortality rates, social security, the Monte Carlo simulation and so on. Since it is complex I won’t go into detail here but I encourage you to check out the study and take a look at some of the tables they have provided that give some sample income levels you can use to compare with your own situation.

What This Means For You

After all of this discussion you are probably just as confused as before. Making general assumptions only goes so far, yet if you’re getting close to retirement and put together a detailed estimate you’ve already missed out on a lot of time needed to save, so what should you do? Ultimately you shouldn’t get hung up on some of the numbers out there. Just because some talking head on TV says you should have a million dollar portfolio by age 65 doesn’t mean that is what you should strive for, just as the rule of thumb saying you need to save 10% of your income or have 80% of your income during retirement might not be appropriate for you. People are unique and everyone’s situation is different.

Use these guidelines as a starting point. Read the study and go over some of the examples they provide. While in the end they are still general assumptions they are a great place to start, it is then up to you to monitor your progress and make changes as things in your life change. It is hard to say where life will take you so your actual savings goals may change significantly. If you start saving early and find out you’re saving more than you need to that is a good problem to have. It doesn’t hurt to overestimate because you can do even more in retirement or leave more to your heirs or charity, but if you realize at age 50 that you haven’t saved nearly enough you can’t go back in time and fix it. In the meantime, be sure you’re maxing out those IRAs and not hurting your retirement chances by taking a 401k loan.

Resource: National Savings Rate Guidelines for Individuals

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

11 comments
Englewood Insurance
Englewood Insurance

Personally, the sooner one learns about financial planning, including retirement planning  and insurance protection, the better one would be later on in life. Its sometimes scary that a lot of people in their late twenties to mid thirties still haven't even started building up their nest egg yet. 

BarbaraWSimms
BarbaraWSimms

We all need some kind of security once we retire. When you start early, you have enough money to enjoy later on. With regard to saving too much, you should ask yourself and make a decision how much you think you need to live a comfortable life later on.

nathanieltoney
nathanieltoney

I think there is no ballpark figure for that. Even the 'rule of the thumb' doesn't apply to everyone, which I think also everyone knows. You need to visualize what you want to do after you retire. You may want to avoid feeling useless when you no longer have an income, travel the world, or visit and rekindle the bonds with your long-lost friends and families. Have a target and plan and save for it.

deecarreon
deecarreon

No matter how much you saved for your retirement, you should know how to properly handle them. Know how to manage your money because if you are not careful enough, you might not enjoy the fruits of your hard-earned money. It's good to retire. But it would be better if you are retired and not broke.

Your Own Retirement
Your Own Retirement

I think one of the most important things when trying to plan your retirement is sitting down and putting together a comprehensive game plan of all aspects of your finances. Sometimes in order to retire comfortably and safely you have to visualize where you can make sacrifices to make room for certain retirement elements.

steve
steve

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retirebyforty
retirebyforty

401k and ROTH IRA are not enough for retirement unless you max out early and often.
A great alternative is rental income! I am maxing out 401k and also working on a rental income revenue stream. I believe this is the way to go.
For younger people, you need to learn to be frugal and read the Millionaire next door. Play great defense!

Nick
Nick

Lots and lots of people are wondering if they'll ever have enough money to retire in their lifetime, it's scary out there. Any 401k alternatives out there that people have turned to (besides IRA, Roth IRA)?

Tyrel
Tyrel

Lots of people are asking this question today, especially as a lot of people are losing their jobs, moving around, and because of the general downturn in the markets. Has anyone considered using a financial planner, even at a young age? We're throwing together a site to bridge the gap between investors and advisors... but just wondering if anyone uses an advisor to help understand their needs?

Josh
Josh

Also people need to look closer at their 401(k) plans. It's pretty safe to say taxes are going to go up, and when you pull that money out of your 401(k) in however many years what tax bracket are you going to be in?

Alot of retiring people now are having that same problem and finding that taxes are putting them in a bad position, they don't have enough money.

Like the article says, carefully plan. It's the best way. Look at all your options. There are many alternatives people don't know about.

David Wilson
David Wilson

Thanks for the post, great information. People forget that making small changes can make a huge difference in the overall financial status.

starshard0
starshard0

I started saving for retirement when I was 18, and have been increasing the amount I save as much as I can. I try to put away 80% of my income into various investments. I'm shooting for $1,000,000 by the time I'm 35, but even half of that would be awesome.

Moneyedup
Moneyedup

@ Credit Girl, Saving as much of your part-time income as possible is a great idea, but make sure that you leave some money in a savings account that you can tap into in case of emergencies. Once you start saving for your retirement and you put the money away in a retirement savings account you will have to pay hefty penalties if you need to take out the money to use before your retirement. So, start saving as early as possible, but also put some aside in an emergency savings account for unexpected school expenses, car repairs or rent payments. You are definitely on the right track!

Credit Girl
Credit Girl

How much to save and when to start saving for retirement is also a common problem for me as I am starting to hit my twenties. I think for now I'm just going to save as much of my part-time income as possible after I pay for my basic necessities.