If they haven’t already made the decision to retire, baby boomers come closer to facing this decision each year. Like them, you’ll need to determine how much money you’ll need when you retire. There are two ways of looking at your retirement needs–your total savings and your annual retirement expenses. To live a fulfilling retirement, it’s best if you have a comfortable handle on both of these numbers.
Start off by gathering the facts. This includes your current expenses, expected Social Security benefits, pension payments and any other income sources during retirement. One quick method to determine your expenses is to look at your total income and subtract the money you saved (including any 401k deductions). You can obtain information regarding expected Social Security benefits directly from the government and information on any pension payments from your employer. Other income sources might include royalties, investment income and part-time jobs.
Getting a handle on your current expenses is considered the first step to determining how much money you’ll need for retirement. Many financial planners will tell you to simply take 70 to 80 percent of that number and use that as a guide for estimating retirement expenses. This is an acceptable rule of thumb, but can often produce misleading results. For example, if you expect to have your mortgage paid off by the time you retire, your annual retirement expenses could be far less than three-quarters of your current expenses. On the other hand, if you plan to increase your travel plans, your retirement expenses may equal or even exceed your current expenses. For these reasons, you’ll need to not only obtain current expense information, but project any significant additions and deletions to those expenses that might occur during retirement.
Once you’ve got a good handle on your annual retirement expenses, you can then determine how you might pay for those expenses. For example, if you’re eligible for Social Security benefits or company pension payments, identify their annual value and subtract that from your annual retirement expense. What’s left is the amount of living expenses that must be made up either by investment income or other sources of income. We’ll call this number your “income gap.”
Size of Retirement Savings
After determining your income gap, you can easily calculate the amount of money you’ll need to save for retirement. Using a method similar to nonprofit endowment trustees, simply multiply your income gap by 20. This yields the total amount you should save for retirement and assumes you’ll withdraw 5 percent annually from this savings account to close your income gap.
Many people make two mistakes when figuring out how much they’ll need for retirement. First, they underestimate their expenses. The likelihood of this increases if you don’t use personal finance software like Quicken to keep track of all your expenses. Folks also tend to underestimate the additional costs of their retirement activities. Don’t forget to add those in. Second, many people often fail to properly account for inflation. They will either disregard it or count it twice. Again, software like Quicken will contain a retirement plan calculator that includes the impact of inflation. If you need to enter an estimate for inflation, most financial professionals will use a 3 percent estimate based on current trends.