When it comes to retirement planning, most people focus on how much money they need to save up before they quit their jobs for good. But that's only half the battle. You also need to know how much money you can withdraw from your savings each year in retirement without exhausting your funds.
Conventional wisdom says that retirees' biggest challenge will be reining in their spending to avoid running out of money during their golden years. However, 68% of retirees aren't withdrawing any more from their 401(k)s or traditional IRAs than they're required to per their required minimum distributions (i.e., the minimum amount you are required to withdraw from your retirement accounts each year once you turn age 70 1/2), according to a study from Ameriprise Financial.
That's not necessarily a bad thing -- after all, frugality is a good trait for a retiree living on a fixed income. However, the study also revealed that only 21% of retirees feel confident about how much they can withdraw each year to ensure their money lasts the rest of their lives.
In other words, retirees aren't spending their money because they don't know how much they can spend safely.
Making your money last through retirement
The bad news is that there's no magic formula to determine exactly how much you should withdraw each year. The good news is that you don't have to blindly guess and hope for the best.
The 4% rule is an oft-used guideline that's a great place to start. The rule states that if you withdraw 4% of your nest egg during the first year of retirement and then adjust that amount each following year for inflation, your savings should last roughly 30 years. For example, if you have $500,000 saved for retirement, you'd withdraw $20,000 the first year ($500,000 x 4%). If inflation came to 2% over that year, then you'd withdraw an extra 2% of the base $20,000 (or $400) during the second year -- that's $20,400 altogether.
Of course, no rule is foolproof, and the 4% rule is no exception. For one, it assumes your retirement will last 30 years or less. That may sound like a long time, but with life expectancies continuing to increase, there's a good chance your retirement will last longer than three decades. The Social Security Administration estimates that 1 in 4 Americans aged 65 today will live past age 90, while 1 in 10 will make it past 95. So if you retire at 62 and live past 92, you could run out of money even if you diligently follow the 4% rule.
That being said, it's better to have a plan -- even a rough one -- than to simply withdraw however much you think you need each year and hope you won't run out of money down the road.
Planning for retirement -- the right way
Before you can figure out how much money to withdraw from your savings each year, you should determine how much you'll need to make ends meet. Then you can work backwards to make sure you've saved enough to meet that goal.
To start, create a thorough budget detailing all your expenses to calculate how much you spend each year. Some of these expenses may change once you retire -- for instance, you may spend less on fuel when you no longer have to commute to work, but you'll likely face rising healthcare costs as you get older -- so try to account for that in order to paint an accurate picture of your income needs in retirement.
Group your expenses into different categories based on how important they are. For example, you may have one category for necessary expenses (your mortgage, groceries, car payment, etc.) and another for nice-to-have expenses (travel, hobbies, etc.). Then when you calculate your total yearly expenses, you'll have a more realistic view of how much you truly need to get by versus how much you'll need to live comfortably.
It's also a good idea to consider how much you'll be receiving in Social Security benefits, as that will give you a better idea of how much annual income your independent savings will need to provide. The average beneficiary receives around $1,300 per month (or $15,600 per year), which can go a long way in covering expenses.
Once you know how much money you'll need to cover your basic expenses, you can work backwards using the 4% rule to determine how much you should save by the time you retire. For example, say you need $40,000 per year to cover all your basic expenses or $50,000 per year to live a more comfortable retirement. If you're receiving $15,000 per year in Social Security benefits, that means you'll need to come up with $25,000 to $35,000 on your own each year. Working backwards, if $25,000 or $35,000 amounts to 4% of your total retirement fund, multiply those numbers by 25, and you'll have your retirement savings target.
In this instance, that amounts to between $625,000 and $875,000, depending on the lifestyle you're aiming for. So if you want to withdraw 4% of your nest egg the first year, and you know you'll need a total of $40,000 per year, then you'll need $625,000 in independent savings by the time you retire. If you want an extra $10,000 per year in fun money, you'll need to stash away another $250,000 by retirement.
Retirement planning isn't an exact science, but that doesn't mean you can't plan strategically. Even a rough estimate of how much you're able to withdraw each year will help your money last longer, which will, in turn, make retirement far more enjoyable.