Figuring out how to pay for retirement is something millions of people stress over every day. This is especially true for those who won't be counting on a significant amount of income from a pension plan. The good news is, IRAs are a wonderful tool that almost anyone can use to build up their retirement nest egg.
The catch? Knowing exactly how much money you'll need to have saved in order to generate the amount of income you'll expect to have. However, there's a simple formula that can help you start determining exactly how much you should have in your IRA, 401(k), and other accounts when you are ready to retire.
How this simple rule can get you started
Back in the early 1990s, a financial advisor in California developed something that's now known as the "4% rule." The premise of this rule is that your retirement accounts will generate sustainable income to last as much as 30 years, if you withdraw 4% of the balance your first year and then increase that dollar amount by inflation each year thereafter.
The 4% rule isn't perfect, and it may not be exactly right for every person, but it's still an excellent starting point, especially for anyone still years away from retirement. And that makes it a great way to determine both how much income your current IRA balance would be worth if you retired today, but also a good way to calculate how much more you'll need to have when you do retire to meet a certain level of income.
Here's a simple chart that shows how much you'll need in your IRA, for every dollar in annual income you expect to get:
In short, each dollar of income you expect to withdraw should be backed up by $25 in your IRA when you retire. In other words, if you expect to get $10,000 in income from your IRA, you'd need a $250,000 account balance. For a $100,000 annual income? $2.5 million balance. This is variously called the "rule of 25" or the "25 times rule."
When used with the 4% rule, these two basic formulas give you a starting point to figure out both how much income your current retirement savings will generate and how much more you'll need to have saved when you retire to generate the amount of income you'll need.
How do you get there?
These numbers can seem really daunting. After all, it would be pretty difficult for most of us to set aside $1 million if we will need $40,000 in income from our IRA. This is where another important mathematical concept comes into play: compounding growth.
My colleague Matt Frankel wrote about this last year, under the exact same headline as the article you're reading now, and I can't disagree with the importance of his message, shown in this chart:
Here's the short story on the math above. Over 40 years, a person contributing $5,500 per year to an IRA (the current limit), and capturing the market's historical 9.4% annualized returns, would end up with an account balance of more than $2 million. Here's the awesome catch: They would have only contributed $220,000 out of their pocket. The market's compounding returns would have generated nearly $2 million in growth over that period.
Of course, there are no guarantees that the market will deliver those same returns, but the point remains true: Investing for the long term in great stocks will generate far more growth than trying to save your way to retirement.
Use these rules of thumb as a starting point
These aren't perfect rules that fit everyone. But in general terms, they will absolutely help you determine how much income your current IRA and 401(k) balances would generate if you retired today, as well as help you determine how much more you'll need to generate the income you'll expect.
And once you know how you're doing, you'll be in a much better position to take the necessary steps to ensure you're financially prepared for retirement when the time comes. No better time than now to start measuring your results and taking steps to get where you need to be.