Step 7: Plan for Retirement

You have your finances in order, maybe have a Drip or two, and perhaps are contributing to your 401(k). You may also have opened a brokerage account. Way to go!

But what is all of this investing for, if not to be used and enjoyed at some point? Close your eyes and envision yourself sunbathing on Maui's black-sand beaches, or sipping cappuccino in Carrara, where Michelangelo chose the stone out of which he carved his David and Pieta. That is why you're investing.

Sculpt thyself
Your retirement plans may now be a mass of shapeless stone weighing you down. What we propose to do here is to take out our modern-day hammers and chisels to mold something precise from that stone. But before you start pounding the chisel -- and maybe hacking off your sculpture's femur by accident -- you may be itching for a little guidance.

The six steps
To ensure a successful retirement -- whether you want to quit the workforce at 35 or 70 -- you must:

• Think about what kind of lifestyle you want in retirement, and how much you're going to need per year to support it.
• Figure out how much you'll need on the day of retirement, to make sure you can draw the amount you need. (See the "multiply by 25" rule below.)
• Take an educated guess at how long you'll be retired.
• Decide where you will live, and whether to rent or buy.
• Ensure that you have adequate health, medical, and other insurance for the family.
• Decide how to fill the hours in a day previously devoted to work.

The "multiply by 25" rule
There's a handy (though not entirely accurate) little formula to help you figure out how much money to set aside now so you can meet a certain annual expense for a long time. First, figure out your real rate of return (that is, adjusted for inflation) on your savings. For example, assume that your long-term overall annual rate of return on all investments will be 8% and that inflation will run 4%. That gives you a real rate of return of 4% (8% minus 4%). You divide that 4% into 1.00, and you get 25. Then multiply your annual expense in retirement by that number to arrive at the "lifetime expense." That's a very rough estimate of how much you'll need to have on your retirement date to cover those costs in the future.

Another way of expressing it is to say that you need to put aside $25 to fund each $1 of annual spending in your budget. If your total annual spending in retirement will be $50,000, the "multiply by 25" rule indicates that you need to save $1.25 million before you give up the paycheck.

Though not perfect, this equation allows you to consider various scenarios. What if it were possible to cut your retirement spending to levels well below your current spending? If reducing your expenses allows you to get by on less income, you'll lower your tax burden as well. So taking the above assumption, if you were able to bring your annual spending in retirement down to $30,000, the "multiply by 25" rule indicates that you would need to put aside $750,000 before retirement, a considerably smaller amount. Of course, if you invest well, then you actually have to "put aside" much less and let investment returns make up the difference.

Keep in mind that this calculation does not incorporate Social Security, pension benefits, money you may earn from work after retirement, marrying into a fabulously wealthy family, and so on. It assumes no other sources of income than your investments. This will not be the case (we hope), but it's better to err on the conservative side.

How long will you be retired?
This consideration has two parts: when you will retire, and how long you will live.

You choose when you retire. Whether it's 35 or 55 or 69 or 88, it's your choice. Then, to get a genetically informed guess on how long you may live, take a look at your parents and grandparents. Who lived the longest among them? Take that age, add 10 years to it (you're eating your leafy greens, right?), and use that number.

Subtract from that the age you'll be when you retire, and voila! You have a working number for how long you may be retired.

Where you stand
To arrive at a target amount on your retirement date, you must determine your current financial status. If you use a software program such as Quicken or Money, you'll find your work simplified. Essentially, you need to tally up how much money is coming in right now, and also what you have in terms of assets. You're invested in the stock market, right? Since you know the date your retirement is to begin, our online calculators should help you project how much your portfolio will be worth at that time. You can then compare that with the amount you know you'll need on the Big Day and see whether you need to invest more.

We should mention, of course, the magic of compound interest. The longer you have for your investments to grow, the larger the growth will be. That's why there's no time like the present to begin.

Act!
Check to see whether you have these important weapons in your arsenal:

• Employer-provided pensions, otherwise known as defined benefit plans. These plans are dying off as employers switch to 401(k) plans or hybrid vehicles such as cash balance plans.
• 401(k)s or 403(b)s. Your employer may match the contributions that you make to this plan, up to a certain amount -- and that means you're getting free money. Free money … hmm ... we like the sound of that. Couple the free money with tax-deferred compounding, and you have a great tool for amassing a sizable stash by the time you retire.
• IRAs. If you're eligible, there's no good reason you shouldn't have one of these -- whether you choose a Roth IRA or a traditional IRA. Each provides great tax advantages and the flexibility to be invested in the stock market all the while. The Roth IRA is appealing because if you follow the rules, you can withdraw money you've contributed to it, as well as any earnings on the money, completely tax-free.

Periodically, you must evaluate your progress toward meeting your retirement needs and then make revisions where necessary. We recommend that you check in at least once a year. After all, things change -- rates of return, unexpected expenses, and so forth. One way to keep informed is through our Motley Fool Rule Your Retirement newsletter service, which you can sample free for 30 days.

The early bird and the can of worms
Planning for an early retirement is much more difficult than for a "normal" retirement. For one thing, obtaining adequate health and medical coverage can put a huge dent in the family's income. Medicare isn't available until age 65, yet many employers won't allow group plans to be carried into retirement beyond the 18 months required by law, and individual health policies may cost in the hundreds of dollars per month.

Invest well
We hope we've made it clear that investing well is crucial to your having the resources you'll need on the day you retire. The greater your returns over time, the more money you're going to have.

So how do you evaluate companies in which to invest? We'll discuss one important step next: Reading financial information.