Figuring out how much money you'll need to retire comfortably is a difficult task, but it's also an important one. You'll have to accept some margin of error in your calculations and plan accordingly, but there is a relatively clear three-step process that you can use. Even if the numbers change over time, the methodology is important -- and going through that process will teach you a lot about the most important retirement planning principles.
Forecast a budget
Setting a budget can be a challenging exercise for any period several years in the future. You'll have to accept some margin of error on any forecasts, but it's still an important step in retirement planning. Everyone should have a realistic picture of how much cash they'll need each year after they stop working.
Budgeting starts with the costs of basic needs -- food, shelter, transportation, clothing, and so forth. Many retirees have paid off their mortgage, but they still need to consider property taxes, as well as home maintenance expenses. Other people need to build mortgage or rent payments into a monthly budget. Most people spend $300 to $500 each month on groceries, but this can vary over time due to inflation or commodity market conditions. The average person spends $100 to $200 per month on clothing, so that should be reflected in your financial plan. It's also important to consider car payments, maintenance, insurance, and public transportation costs in the baseline.
Image source: Getty Images.
Healthcare is another important expense category. Most retirees have coverage for hospital expenses through Medicare, but a combination of supplemental insurance and out-of-pocket costs cover a wide variety of other medical and dental costs. The average American currently spends around $6,000 annually on healthcare during retirement, and that will continue to rise with inflation. Healthcare is expected to represent roughly 15% of total household spending for seniors, so it's important to consider this portion of your budget.
Most people don't want to lead a bare-bones existence in retirement, so budget planning should reflect lifestyle goals, too. This would include any travel, dining out, entertainment, and discretionary items, such as fashion, sporting goods, or electronics. There's obviously some wiggle room on non-essential spending, but goal setting should be somewhat aspirational. If you want to figure out how much you need to save, this has to be part of the calculation.
Once all the significant cash needs are identified, they can be summed up. It's smart to over-estimate these items if possible to build in some cushion for unexpected expenses. Never forget to factor inflation into the calculations, especially if you're a few decades away from retirement.
Identify and quantify sources of cash flow
Once you've estimated roughly how much you'll need each month and what your year of retirement will be, you have to determine where that cash will come from, and how much each resource will provide.
Social Security is an important part of most retirement plans. These are guaranteed monthly payments that are adjusted for cost of living every year. The average monthly benefit is around $1,700 right now, so the contribution is somewhat modest. Still, it's an important base for most people and it keeps many senior households out of poverty. There are several helpful tools available to estimate your monthly Social Security income, including the Social Security Administration's own website.
If your employer offers a defined benefit pension plan, that's an enormous resource. These plans give you guaranteed, regular checks in retirement. Defined benefit pensions aren't very common among employees of private companies any more, but they're still available for many government employees and union members. The plan administrator can typically help you to forecast the amount of income you can expect to receive in retirement.
Consider the 4% rule
Cash needs above and beyond the income provided by structured resources such as Social Security or pensions generally have to be covered by distributions from accumulated assets. These assets could be housed in a 401(k), an IRA, a Roth account, a brokerage account, or a variety of other vehicles. Some people use annuities to automate this process, and many others develop a distribution plan to turn their assets into cash flows.
This is the final step to calculating the amount you'll need in retirement. Current planning standards indicate that retirees can safely distribute 3% to 4% of their total account value each year without exhausting their assets. Suppose you determine that you'll need $70,000 per year to meet your retirement planning budget. If you expect $1,700 each month from Social Security, there's a $50,000 gap that needs to be covered by other assets. Considering the 4% rule and its modern revisions, you'll need somewhere between $1.25 million and $1.67 million to safely produce that much cash each year.
One final note: Make sure to consider taxes in your calculations. Different income streams are subject to different tax rates. If you're pulling money from a 401(k), those distributions are treated as ordinary income. Any cash needs must be met with after-tax dollars, so taxes necessarily increase the amount you'll need to save.
Having a retirement savings goal is the first step. Once you've done some math to set your goals, you'll have to commit to a savings and investment plan to responsibly build assets throughout your working years.
