There's a common rule of thumb for how much you need to retire that proliferates throughout the financial advice industry, and it's completely useless.
It's quite common to hear that you need to be able to replace 80% of your pre-retirement income with your savings. Some even call it the 80% rule. But it's an absolutely illogical goal to shoot for, so forget about it ASAP.
If you want to know how much you need for retirement, do this instead.
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Where does the 80% rule even come from?
It's not clear where the 80% rule actually came from, but I have a guess as to why it's become so popular.
Consider that the most common savings advice is that you should put away 10% to 15% of your salary for retirement and other savings goals. On top of that, the government taxes you about 15.3% for Social Security and Medicare, but your employer will pay half of that.
So, if the average financially responsible person is saving about 12.5% of their salary, and another 7.65% of their salary goes toward Social Security and Medicare, they're left with about 80% of their salary to pay for life and taxes. And if you want to maintain your exact same lifestyle in retirement, you'll need exactly that much money.
But a lot of people aren't saving 12.5% of their salary. Some save less, some save more, and some save a lot more.
That means most people need to replace an amount different than 80% of their pre-retirement salary.
What you should do instead
If you want to know how much you need to save for retirement, you need to know how much you plan on spending in retirement.
Making a plan for your retirement spending shouldn't be too difficult. Look at what you're spending now, and figure out what you might add or subtract.
If you're not going into a job every day, maybe you'll spend less on gasoline and car maintenance. Maybe you won't have to buy new clothes as often. And maybe you won't eat out for lunch as often.
With more free time, you might spend more on your hobbies. Or maybe you'll travel more.
If you pay off your mortgage before retiring, that's a huge expense going out the window. But you'll still have to pay home insurance and property taxes.
And if you're retiring before you reach eligibility for Medicare, you'll have to factor in the cost of health insurance to bridge the gap between retirement and age 65.
If you can come up with an estimate, even a rough estimate, of how much you expect to spend in retirement, it'll provide a much more accurate picture of your retirement savings needs than relying on the 80% rule.
Work backward to a portfolio size
Once you know how much you need for retirement, determining a savings goal is fairly straightforward.
You can follow the 4% rule, which says you can safely withdraw 4% of a retirement portfolio every year, adjusting for inflation, with a minimal risk of running out of money in a 30-year retirement. The rule is based on maintaining a 60/40 asset allocation between stocks and treasury bonds. While it's held true since its inception in the 1990s, never failing, many have called into question the wisdom of the 4% rule after recent market turmoil sent both stock and bond prices lower.
If 4% feels too aggressive, you should feel much more comfortable with a 3.33% withdrawal rate. And the more wiggle room you have to cut back in your budget, the more confidence you should have that you can make a higher withdrawal rate work in the long run.
Once you settle on a withdrawal rate, you simply divide your annual spending minus any pensions and Social Security benefits by your withdrawal rate, and you have your retirement savings goal. So, if you expect you'll need an extra $50,000 per year and use a 3.33% withdrawal rate, you'd need $1.5 million in retirement savings.
Ditch the 80% rule and stick with estimates that make more sense for your own situation. You'll have a much more successful time saving and living in retirement if you put in the little extra effort to figure out your expected retirement spending.
