Will your retirement savings last for the rest of your life? This depends on how much you have, how much you need to withdraw, inflation, and the returns your investments earn. Nobody has a crystal ball that tells you exactly how long your money will last, but here's the next best thing.
How much can you reasonably expect to earn on your savings?
First of all, when I say the word "savings," I'm not referring to the emergency cash you have stashed away for a rainy day. Rather, I'm talking about the money you have invested, or are specifically saving for retirement.
Your investment returns depend on many factors, and are not predictable over shorter time periods. However, we can look at historical averages to come up with realistic estimates.
The stock market, as a whole, has historically produced annualized total returns of about 9.5% per year, give or take a percentage point or so (depending on the data set you use). And bond investments have historically returned in the 4%-5% range per year.
For an investment portfolio that's invested in 50% stocks and 50% bonds, it's completely reasonable to expect long-term average annual returns in the 6% ballpark. You can increase this estimate by a percentage or two if you have more in stocks, and reduce it if you have a more bond-heavy portfolio, or if you keep a good chunk of your savings in cash.
However, keep in mind that this is an expected average. In any given year, your portfolio could take a nosedive. If you were invested in 2008, you probably know this already; however, it's easy to forget when the market has been going up for several years.
How much can you withdraw?
The most frequently used guideline is known as the "4% rule" of retirement. Basically, this rule says that if you withdraw 4% of your savings during the first year, and give yourself cost of living increases in subsequent years, your money should last for at least 30 years.
While this rule is admittedly far from perfect, it's a pretty good rule of thumb to start with. To calculate your monthly withdrawals using the 4% rule, simply divide your total savings by 25, and then divide that result by 12. For example, if you have $1 million saved, the 4% rule says that you can withdraw $40,000 during the first year. On a monthly basis, this is $3,333.
Don't forget about inflation
While inflation hasn't been much of an issue over the past few years, you can count on it over the long term. Over the 100-year period from 1913-2013, the average inflation rate in the U.S. was 3.22%. So, expect something in that ballpark, on average.
What this means to you is that you should anticipate needing more of your savings as time goes on. In our previous example, if you're withdrawing $40,000 from your savings this year, based on historical inflation rates, you should plan on $41,228 next year, and $42,617 the year after that.
What about taxes?
The calculator you're about to see has a place for your marginal tax rate. This refers to the tax you'll pay on your investment returns, and in order to determine what your tax implications will be, you need to consider which of the three types of accounts your savings is in.
- Standard (taxable) brokerage account: Unless your savings are in some sort of retirement account (401(k), 403(b), IRA, etc.), this is probably what you have. You'll have to pay tax each year on the dividend and interest income your account earns, as well as capital gains tax when you sell an investment at a profit. Fortunately, most dividends and capital gains are taxed at a more favorable rate than ordinary income -- 15% for most tax brackets.
- Pre-tax retirement account: Traditional IRAs and most 401(k)s fall into this category. The money you contribute is excluded from your taxable income in the year you make the deposit. And you don't have to pay dividend or capital gains tax on a yearly basis. However, any withdrawals are considered taxable income. Your taxes are not taken from investment interest and gains at all. For purposes of this calculator, your marginal tax rate on interest is 0%; just be aware that you might have to pay taxes on your withdrawals.
- After-tax retirement account: If you have a Roth IRA or have made Roth 401(k) contributions, you're in luck when it comes to taxes in retirement. Since you already paid taxes on the money you contributed, any qualified withdrawals are 100% tax free. In other words, for investment gains in a Roth account, your tax rate is 0%.
Fortunately, you don't need to guess or do any tough calculations here -- we have a calculator that can help you determine how long your money will last. Use the information we've discussed when determining what numbers to use, and you should get a pretty good ballpark figure.
Keep in mind that nobody knows for sure what inflation will be, or the return you'll get on your investments, or what changes might be made to the tax brackets going forward. This is meant to be used as a guide, not a month-by-month account of how your savings balance will look.
Let's say that you have $700,000 in a Roth IRA and are wondering whether or not you're ready to retire. You need $3,000 per month in retirement income, and can reasonably expect your investments to gain 5% per year. For simplicity, we'll assume the historical average inflation rate of 3.22%.
According to the calculator, you can expect your money to last 24 years. That's not quite long enough to ensure a financially comfortable retirement, so you could wait a few years and allow your savings to grow.
Calculators like this one are only useful if you're realistic with your inputs. If you assume that you'll earn 12% per year on your retirement investments and inflation and taxes won't exist, the calculator will tell you that you can withdraw $120,000 from your $1 million nest egg every year forever. However, that's not a realistic scenario.
The bottom line is to be conservative in your estimates, and err on the side of caution. After all, the last thing you want is to get 25 years into retirement and run out of money because you withdrew your savings a little too aggressively.