Retirement is a milestone most of us will someday reach, because few people work until the end of their lives. But only around one-third of Americans are very confident they'll have enough money to live comfortably -- and some may actually be too confident, because we tend to overestimate how long we'll stay in the workforce and underestimate how much healthcare will cost.
To make sure you'll have enough money to live on during your golden years, it's important to figure out how much money you need to retire. This can be more complicated than it seems, because there are different theories and formulas -- but this complete guide will help you determine how much you should have available before you leave the workforce for good.
How much money will you need as a senior?
To determine how much money to save for retirement, you should figure out how much money you plan to spend.
Once you have this number, you'll consider all of your sources of retirement income to make sure expected income matches expected outflow.
If it doesn't, you'll need to adjust your expectations and scale down your expenses or -- if you still can -- find ways to increase the income available to you in retirement.
Determining how much you'll need to live on
One of the most difficult numbers to figure out is the amount of money you'll need to live on as a senior. That's because it's hard to predict the future.
There are some rules of thumb that can help you to make an educated guess about the amount of money you'll require. For example, many financial experts suggest you'll need to replace 80% of the income you earned while working.
But, these rules may not provide an accurate estimate for every senior -- and you also need to make certain you don't forget big expenses such as healthcare.
Estimating retirement spending based on preretirement income
The premise that you're supposed to live on 80% of your preretirement income as a senior could either overestimate or underestimate your spending, depending what you're doing with your income during your working years and what you plan for retirement.
Consider two different people. One spends 90% of income on rent, inexpensive home-cooked food, and basic clothing. The other spends 30% of income on essential expenditures and devotes the remaining 70% toward saving and paying off a mortgage early. The first person might need to replace more than 80% of his or her preretirement income, while the second might need far less.
While this is an extreme example, the Employee Benefit Research Institute found that almost 50% of families end up increasing spending compared with preretirement salaries. Close to one-third of these families actually spend 120% more than they did while working.
To err on the side of caution, you may want to plan to replace between 90% and 100% of preretirement income. It's better to have too much than too little.
Estimating retirement spending using a budget
A percentage formula is inexact, so you may want to create a sample budget for how you'll live as a retiree. Of course, the closer you are to retirement, the easier that is to do.
If you're within a few years of retirement, you should be able to project spending in key categories including:
- Monthly housing costs
- Transportation expenses
- Food costs
- Taxes and insurance
- Clothing and personal care items
- Travel and entertainment
- Contributions to help out adult children or grandkids
If retirement is far in the future and you're trying to estimate spending, think about what you'll change compared with your current lifestyle. Will your home be paid off, so housing costs go down? Will you travel more or indulge your hobbies, so entertainment expenditures go up?
This exercise can help you get an idea of whether retirement spending will be lower than your current income, or exceed it.
How will taxes affect your retirement spending?
Taxes are another key thing to think about when deciding how much retirement income you're going to need.
You'll be taxed on withdrawals from many retirement investment accounts, including 401(k)s and traditional IRAs -- although you aren't taxed on Roth accounts, provided you comply with specific requirements such as not taking money out within five years of opening the account.
If your income is high enough, you could also be taxed on as much as 85% of your Social Security benefits. Once income is above $25,000 for singles and $32,000 for married couples filing jointly, federal taxes begin on these benefits. However, "income" for these purposes doesn't mean total income; it's calculated by adding up half your Social Security benefits and all your taxable income that's not from Social Security.
Income on investment account withdrawals and any taxable portion of your Social Security benefits is taxed based on your standard tax rate. It's hard to predict what that will be in the future, but you can use your current tax rates to estimate.
For example, if you're single and have $50,000 of taxable income, and you're in the 22% tax bracket, you'd currently pay $6,939.50 in annual federal taxes ($4,453.50 + 22% of the amount over $38,700).
Some, but not all, states impose state income tax on pensions and retirement account distributions. And thirteen states tax Social Security too, each using its own rules. Learn your state's tax rules by checking with its Department of Revenue so you can estimate what you'll need to pay.
Don't forget healthcare costs
One of the biggest mistakes seniors make when planning how much they need to save for retirement is not considering how expensive healthcare can be.
A study conducted by the Employee Benefit Research Institute revealed that a senior couple in the 90th percentile for prescription-drug use would need as much as $370,000 during retirement to pay for healthcare. Bureau of Labor Statistics estimates show that mean healthcare spending for seniors is close to $6,000 annually. And seniors are statistically more likely to experience major health emergencies.
Seniors are often surprised to find that Medicare doesn't shield them from high healthcare costs. In fact, you'll need to pay Medicare premiums as well as coinsurance costs, which can be quite high.
Consider having a separate dedicated fund -- ideally in a health savings account -- that you put money into to cover your care during retirement.
Where will your money come from in retirement?
Once you have a reasonable idea of what you'll need to spend, it's time to think about where the money will come from, so you can figure out how big your savings need to be to generate enough income. This means evaluating all of the sources of funds you'll have available in retirement.
If you have a generous guaranteed-income pension and substantial Social Security benefits, you won't need to save as much; these sources of funds may be enough to provide the bulk of your support.
Sadly, most people don't have defined-benefit pensions -- plans in which employers guarantee a certain amount of monthly income for life. Instead, it's much more common to have a defined-contribution plan, such as a 401(k), or to have no plan at all.
If your retirement income will come primarily from 401(k) contributions you make, or if you don't have a workplace plan, you'll need to be aggressive in setting aside funds to have enough for your senior years -- especially as Social Security benefits alone are not enough to support you.
Will you have a pension?
As mentioned earlier, a defined-benefit pension is pretty rare these days -- especially in the private sector.
But if you anticipate having one, talk with your human resources department to find out how much income it's likely to provide you. You'll need to factor this in when calculating how much money you need in retirement.
How much will your Social Security benefits be?
If you don't have a defined-benefit pension plan, Social Security benefits are likely to be the only guaranteed income you'll have to support you in old age. Social Security income will last for your entire life and shouldn't decline in value -- although its purchasing power will likely decline over time.
Social Security benefits are determined based on a formula that calculates an average wage based on the 35 years in which you earned the most money, with wages adjusted for inflation. This average wage is your Average Indexed Monthly Earnings (AIME).
Your AIME is then used to determine your primary insurance amount (PIA). This is the amount you'd get if you didn't claim benefits until the age the Social Security Administration (SSA) designates as your full retirement age.
In 2018, you get 90% of the first $895 in AIME, 32% of the amount between $895 and $5,397, and 15% of any amount above $5,397.
If you create a "my Social Security" account at the SSA's website, you can see estimated benefits at age 62 -- the earliest age at which you can claim benefits -- as well as at your full retirement age (FRA) and at age 70. If you retire before FRA -- which is 67 if you were born in 1960 or later -- benefits are reduced. If you retire after FRA, benefits increase up until age 70.
The calculations on the SSA's website assume your salary will stay close to what it currently is for the rest of your career, so if you expect a big drop or increase in income, you may need to adjust your expectations.
Don't assume you'll be able to delay claiming Social Security
If you claim Social Security well before full retirement age -- at 62, when you first become eligible -- benefits could be reduced by as much as 30%. This chart will show you exactly how much benefits are reduced if you need to retire early.
Unfortunately, while 70% of current workers report they plan to claim Social Security at 65 or later, only 43% of current retirees actually claimed benefits that late, and the median age at which benefits were claimed in 2018 was 63.
If you want to make certain you have enough income to live on, it's best to underestimate -- rather than overestimate -- how much income Social Security will provide.
In other words, if you're a long way from retirement and trying to figure out how much money you'll need, assume you'll end up taking Social Security at 62.
Will you have other sources of guaranteed income?
Some people also have other sources of income they can expect in retirement, such as money doled out from a trust or coming from alimony payments.
If you expect to continue receiving this money throughout your entire retirement, it can be factored in when you decide how much money you need to save.
However, evaluate whether it's really reliable and likely to last. If you're basing your retirement goals on the premise you'll keep getting big spousal support payments for the rest of your life, and your ex passes away at 50 so you end up getting nothing, you'll be in dire straits.
How much savings will you need to produce your desired retirement income?
Since you can't do a lot to control your Social Security benefits or pension benefits, the key calculation to make when deciding how much income you need to retire is figuring out how much savings you'll need.
To determine how much income your savings must produce: Add up your pension, Social Security benefits, and other sources of guaranteed income, then subtract this number from the income you'll need to live on.
If you've decided you need $6,000 monthly, and your pension and Social Security benefits add up to $2,000, you'll need your savings to produce $4,000 per month, which is $48,000 per year. Now you just need to calculate how much savings is required to produce that amount. There are different approaches you can take to do this.
Estimating returns on invested funds
One option is to assume you'll leave the principal balance alone and live only on the returns your money earns. In this case, the first step would be to come up with a conservative estimate of how much you think your savings will earn each year.
Vanguard's 2018 "Economic and Market Outlook" estimates the U.S. stock market will return 4.5% to 6.5% over the next decade, and bonds will return around 2.5%.
Since retirees need a pretty conservative portfolio because they don't have time to weather market downturns, you may want to err on the side of caution and expect investments will return only 3% to 5%.
This would mean that if you need your investments to produce a $48,000 income, you'd have to plan on saving between $960,000 and $1.6 million. You'd figure this out by taking the income you need -- $48,000 -- and dividing it by the returns you expect to earn ($48,000 / .03 or $48,000 / .05).
This is a very conservative approach, because most seniors do tap into the principal on their retirement accounts. But if you want to be on the safe side and make sure you don't run out of funds, this is a good way to set your goals.
You can always use any extra funds to cover healthcare costs that turn out to be higher than expected, or leave more money to your kids.
Using a percentage-based rule
Another approach to determine how much income your savings should produce is to work backwards from the 4% rule. This is a basic rule of thumb that says you can take out 4% of your retirement account's value when you first retire, and then increase that amount each year based on inflation.
If you plan to adhere to the 4% rule and want $48,000 in income during retirement, you'd divide your annual spending by 4% to see how much you need to save. Since $48,000 / .04 = $1.2 million, you'd need a nest egg of around this amount to produce your desired income using our above example.
Unfortunately, some experts caution against using the 4% rule, given expected low interest rates, as there's a significant chance you'll run out of money. Instead, you may want to choose a lower percentage.
The Center for Retirement Research used Required Minimum Distributions tables from the Internal Revenue Service to estimate the amount of money retirees of different ages should withdraw from their retirement accounts.
if you followed the center's recommendation, and you retired at 65, you'd withdraw 3.13% from savings in your first year of retirement. You could use the same basic calculation -- $48,000 / .0313 -- to see that you need a nest egg of around $1.5 million.
Using simple multiplication to determine your savings goals
Financial experts have come up with other rules of thumb they recommend for estimating how much savings you'll need for retirement.
One of the simplest approaches is to take your final salary at retirement and multiply it by 10 to determine the total amount of savings you need. For example, if you're making $72,000 annually at retirement, you'd need $720,000.
If you take this approach and follow the 4% rule, this would mean you'd get around $28,800 in income from savings during your first year of retirement.
Depending how much income you need, and how much you'll receive in Social Security benefits or pension income, this might be just enough or it might be too little -- but at least it gives you a starting point to work from if you're not sure where to begin.
Start saving for retirement today
Now you know a few different ways to calculate how much income you'll need to retire. Unfortunately, many Americans are saving far too little to get anywhere close to the amount they'll need to live comfortably during their golden years.
Start saving as much money as you can today, so at least you can get on the right path toward building a secure nest egg. Over time, increase that amount, so you can reach your savings goals and have the funds you need to be a financially secure retiree.