Every Fool knows the importance of saving for retirement. But one massive, mind-boggling question can scare away even the most well-intentioned investor: How much cold, hard cash will you actually need to fully fund your golden years?
Finding the answer is easier than you think.
Step 1: Choose an annual income
Forget 30, 40, or even 50 years from now. How much money per year would you need to live comfortably right now? I'm talking about food, shelter, those little luxuries you can't do without, and enough cash left over for the occasional vacation or big-ticket splurge.
If you're living comfortably on your current take-home pay, you shouldn't necessarily add extra for health insurance, prescription drugs, and other expenses that increase as we get older. By the time you get to your "senior citizen discount" years, you'll probably be spending less on food and housing, and you'll occupy a lower tax bracket, too. And once you're actually in retirement, you'll no longer have to devote a chunk of your income to saving for retirement.
Once you've got an amount in mind, round it to the nearest multiple of $10,000 -- it'll make the next step even easier.
Step 2: The 4% solution
According to Fool retirement guru Robert Brokamp, the grand poobah of our Rule Your Retirement newsletter, most experts currently agree that drawing down 4% of your retirement holdings per year is the best way to make sure your funds last as least as long as you do. In short, for each $10,000 per year you use in retirement, you'll need a total of $250,000 in the bank. So if you're planning to live comfortably on $50,000 a year in retirement, you'll need to have $1.25 million saved by the time you get there.
Or will you? Like that movie where the soldiers are stalked by an invisible predator, and they have to defeat this predator to save the planet -- I think it was called Scary Dreadlocked Jungle Creature -- there's an unseen hunter out to bleed away your retirement savings. Arm yourself now to fight it off.
Step 3: Adjust for inflation
It's sad but true: The dollar bill sitting in your wallet today won't stretch quite as far a year from now. By the time you retire, you'll be able to regale your grandchildren with stories of how much that dollar could buy when you were a child.
Thankfully, the Internet provides calculators that can tell us how much future cash we'll need to match today's spending power so we can plan ahead. Head over to Tom's Inflation Calculator, and then plug in the total amount you'd need to retire right now and the approximate year in which you expect to retire. (The calculator's good for any year up to 2050.)
The resulting amount will show you how much you'll need to have then so you can live like you plan to now. If, like me, you're a good 40 years away from retirement, the change can be shocking. But don't despair -- inflation may be your enemy, but time is still on your side.
Step 4: Compounding to the rescue
Moneychimp.com's Compound Interest Calculator can help you plan your savings strategy. Start with your current total retirement savings and how much you're willing or able to invest each year going forward, whether in a brokerage account, 401(k), or IRA.
Next, plug in an interest rate -- 10%, the historical annual average growth of the entire stock market, is a fair place to start -- and the number of years until you plan to retire. Then compare the resulting number to your ideal nest egg.
If you're still falling short of your ultimate goals, consider socking away a bit more money each month. Small increases in your savings now can reap huge benefits down the line -- as can a few more percentage points of annual interest. Compounding $10,000 for 40 years at 12% interest yields more than $930,000, compared with roughly $452,000 at 10% interest.
If the market can match its 10% historical growth rate (no guarantee, of course), simple investments in index funds like Vanguard Total Stock Market (FUND: VTSMX ) should help you comfortably reach your goal. And if you want a little extra juice, don't assume you'll have to turn to the latest obscure rocket stocks to find it.
In his book The Future for Investors, market whiz Jeremy Siegel compiled a list of big, familiar companies that averaged annual growth of 15% or more from the late 1950s through the early 2000s, including Altria (NYSE: MO ) , Bristol-Myers Squibb (NYSE: BMY ) , Abbott Laboratories (NYSE: ABT ) , PepsiCo (NYSE: PEP ) , and Coca-Cola (NYSE: KO ) . With dividend reinvestment, even the modest growth of major corporations like these can reap huge rewards for your portfolio in the long run.
Save now, party like a rock star later
Knowing how much you'll need in retirement -- and what you need to save now to get there -- puts you in the driver's seat of your financial future. The steps above will give you a good general idea, but if you'd like to get even more specific, you can take advantage of our powerful retirement calculators with a free 30-day trial subscription to Motley Fool Rule Your Retirement.
When you take Robert Brokamp's service for a spin, you'll also get full access to back issues packed with useful information and message boards filled with friendly Fools ready to help you plan your next step toward retirement. Why not give it a try? You've got nothing to lose and everything to gain.
Fool online editor Nathan Alderman steals all of his best jokes from Homer Simpson. He holds no financial position in any of the stocks or funds mentioned above. Coca-Cola is a Motley Fool Inside Value recommendation. The Fool's disclosure policy always has a plan.