It's a question with an entire industry devoted to answering it: "How much money do I need to retire?" The irony of the situation is that, from a certain perspective, the correct response is incredibly simple.
You can figure out how much money you need to save for retirement by following this simple equation:
Getting a ballpark figure is really as easy as that.
This equation uses the assumption that you can safely draw down 4% of your nest egg in year one, and adjust that figure for inflation every year thereafter.
And you can get a ballpark idea for what your Social Security benefits might look like by going to the Social Security Administration's estimator webpage. If you are afraid your benefits might be cut in the future due to funding shortfalls, simply use 75% of what the estimator tells you.
Where things get a little murky
The part of the equation that becomes more difficult is in figuring out what your expenses might look like once you actually retire. The closer you are to retirement age, the easier this becomes. But even then, there are significant changes in expenditures once someone quits the workforce.
- Because you won't be driving to work every day, transportation costs will fall.
- Food costs generally dip as retirees have time to make food at home instead of being forced to eat out when crunched for time.
- For many, a paid-off house means no monthly mortgage payments.
- Healthcare costs will likely rise.
It's impossible to know with 100% certainty how your costs will change between now and when you retire. But if you want to get a ballpark figure for how much your costs might differ, I've assembled data from the Bureau of Labor Statistic's 2013 Consumer Expenditure Survey.
Simply find your age right now on the x-axis, and adjust your expenditures accordingly.
While it looks like healthcare expenses might drive everyone to the poor house, it's important to keep an eye on the black bars -- which show the changes in overall expenditures. As you can see, the average American will spend far less on housing, food, and transportation in retirement, and this will more than cancel out rising healthcare expenses.
An example from real life
In an effort to show how easy this is, I'll use myself as an example. I'm 33 and my wife is 35, which places us right between the two groups above. Let's assume that our annual expenses will decrease by 20% between now and retirement (adjusted for inflation, of course). That's a nice middle ground between the two cohorts.
- Last year, we spent roughly $52,000. If we adjust that down 20%, that comes to $41,600.
- The Social Security estimator says that if my wife and I claim benefits at full retirement age, we'll receive $34,020 per year. If we adjust that down 25% (assuming a funding shortfall), that comes to $25,515.
So in the end, here's what our equation looks like:
I can't stress enough that this is an inexact science. We might need $400,000, or $600,000. If we didn't include Social Security, our number would be over $1 million.
Right now, my family spends much less than we earn, and it has put us in a good position financially. Should one of us lose our job, have a major medical emergency, or some other huge life change, you can throw this estimate out the window.
That being said, this allows my wife and I to have a general idea for what we'd need by the time we are 67, and encourages us to save even more so that we might be able to retire before we'll need to claim Social Security.
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