You know you should be planning for retirement, kind of like you should be eating right and sleeping a full eight hours nightly. But the more years that are between now and your retirement age, the tougher it is to get specific about what your ideal retirement looks like. And that's when retirement planning can feel too vague to be useful.
Truth is, even a vague retirement plan serves you well -- especially when retirement is decades away. You can always make adjustments to it as your lifestyle evolves, but you can't make up for lost time when you're trying to build wealth. And you'll be more motivated to save when you have a wealth target in mind.
Ready to get started? Here are the four essential steps to planning your retirement.
1. Estimate retirement expenses
According to financial experts, your initial plan can assume you'll need 80% of your working income to make ends meet in retirement. The thinking is that your cost of living will drop when you eliminate work-related expenses and savings contributions. And if you can pay off a mortgage before you leave the workforce, your housing payment obviously goes away, too.
That 80% rule is a decent starting point. And if you have a mental picture of your ideal retirement lifestyle, you can adjust that 80% up or down. You might increase the percentage by 5 or 10 percentage points if you don't expect to have a home paid off, for example, or if you want to spend your retirement traveling. Be cautious about lowering the percentage, though. Although you could reduce your living expenses substantially by relocating and downsizing your home, you don't want to underestimate your retirement income needs.
2. Estimate your savings goal
The big goal to clarify is how much you'll need to save for the retirement you want. You can estimate this by leaning on two additional retirement guidelines. The first has to do with how much income you can expect from Social Security. For most people, Social Security replaces around 40% of working income.
The second guideline is called the 4% rule, which states that in the first year of retirement, you can safely withdraw 4% of your retirement savings. After that, you would increase withdrawals to keep pace with inflation. Follow those guidelines and your retirement portfolio should remain solvent for 30 years.
Like the 80% rule for expenses, these savings goal guidelines can be refined. Your Social Security benefit will be lower if you claim early, for example, and higher if you claim late. You can see how timing affects your monthly benefit by creating an account and logging into my Social Security. Or use the Social Security benefit estimator.
The 4% rule assumes a portfolio of 50% stocks and 50% bonds and a lifespan of 30 years after retirement. You could reduce the percentage slightly if you prefer to plan for the worst or have a more conservative approach to investing your retirement funds. Increasing the percentage is riskier, but some financial planners argue that 4.5% and 5% withdrawal rates are still safe.
Here's the math that'll give you a rough savings target.
- Start with your estimated living expenses. For this example, let's assume you like the 80% guideline as is.
- From that percentage, subtract the percentage of income you'll get from Social Security. Let's assume you want to be conservative here and use 35%.
- The difference, 45%, is the percentage of your current income that you'll need to generate from your retirement savings. Multiply that by your annual salary today to get a dollar amount. If you make $55,000 today, for example, the answer would be $24,750.
- The $24,750 is the amount you'd withdraw from your savings in the first year of retirement. According to the 4% rule, that number should be 4% of your total retirement savings. That means you can divide $24,750 by 0.04 to determine your targeted savings balance at retirement. In this example, $24,750 divided by .04 equals a savings goal of $618,750.
3. Start saving
Now for the fun part -- figuring out how to reach that six-figure savings number. Thankfully, the SEC has a handy savings goal calculator that'll run the numbers for you. Pop in your savings goal, an estimated yield, and the number of years between now and retirement. The calculator returns a monthly savings number required to reach your goal.
For the estimated yield, use 6% to 7% if you're investing your retirement savings in the stock market -- which you should be. Those rates are in line with the stock market's long-term annual average growth rate of 7%.
4. Take the first step
In real life, these calculations might lead you to a monthly savings number that's out of your reach. Don't get discouraged by that. The most important step you can take right now is to initiate that regular savings habit with the highest amount you can afford. Then, raise that contribution every time your pay increases.
Revisit these numbers annually, so you can continue adjusting your contribution to get closer to that savings goal.
Start saving now, refine your needs later
Planning for retirement is tricky from a timing perspective. If you wait until you have all the details, you'll miss your best opportunity to save and build wealth. For that reason, you have to be comfortable relying on assumptions to start and then making refinements to the plan as your lifestyle and financial situation evolves.
The takeaways? Save and invest something, anything, now and check in on your progress in one year. Continue working to bridge the gap between where you are and where you need to be. Wealth-building may be slow at first, but you'll see that growth pick up speed after five years of consistent saving.