Saving for retirement is probably both your largest and your most frustrating financial goal. It's large because the money will have to last you the rest of your life once you stop drawing a paycheck. It's frustrating because there are so many unknowns, such as:
- How long will you live?
- How well will your health hold out?
- How bad will inflation be?
- How much reliable income will you get from Social Security?
Depending on what you put in for estimates for those unknowns, the amount it will look like you will need to save will vary wildly. Still, it is useful to have some guidelines to plan around. With that in mind, these six tips can help you get a great estimate of how much money you'll need in retirement.
No. 1: Know what your costs of living are right now
Most people see most of their costs -- except for healthcare -- decline in retirement. That reality makes your current annual costs of living a decent starting point for figuring out what your retirement costs will be.
If all goes well, your mandatory costs should drop once you stop working. If that happens, then starting by considering what you are spending today can give you a buffer for a more comfortable retirement. If those costs don't drop, then at least you're starting from a framework that can hold your lifestyle around steady.
No. 2: Back out costs that will go away about the time you retire
If you have a mortgage, that mortgage is scheduled to mature and be paid off at some point. If you have kids, they will hopefully be able to take care of themselves. If you have a car loan, once it's paid off, you'll still have the car -- with no payment attached.
In addition, costs you pay specifically to work -- transportation, work clothes, work meals, networking events, etc. -- are costs that you will no longer face once you're no longer working.
From a tax perspective, Social Security and Medicare payroll taxes are collected based on your income from work. Once you stop collecting a paycheck, those taxes go away. Likewise, if you work in a higher tax jurisdiction than you live in, those higher employment-related taxes will also fall away.
Plus, the US federal income tax system is progressive in nature. Generally speaking, the higher your income, the higher your tax rate will be. If, like most of us, your income drops once you stop drawing a paycheck, then your tax rate will likely drop as well.
All these costs are very real ones you may be facing now but might be behind you around the time you stop working. By backing them out of your budget estimates starting around the time they go away, you can get a better estimate of how low your costs could get in retirement without having to change your core lifestyle.
No. 3: Estimate what new costs you will face
For most Americans with full time jobs, health insurance is the largest new cost they will face once they leave employment. If you'll be 65 or older, you'll likely be eligible for Medicare. The Center for Medicare & Medicaid services publishes rates each year for Medicare Part A & Part B and offers a site that lets you shop for supplemental plans to help cover costs base Medicare doesn't.
If you're not eligible for Medicare, HealthCare.gov will let you shop for plans that get you insurance, as well as help you estimate whether you'll qualify for a subsidy based on your household size and income.
While your actual costs for health insurance will vary based on things like your age, household size, and income, it's useful to at least start shopping around now. After all, understanding what those costs would look like today at least gives you a starting point for what you'll face when you do retire.
No. 4: Get a handle on what sources of guaranteed income you'll have
If you're eligible for Social Security, you can create a My Social Security Account to get that agency's best estimate of what your benefit will be when you retire. Of course, what you'll actually receive depends on your earnings record, the age you start collecting, and what inflation looks like between now and when you collect.
Your Social Security benefit will also depend on what actions Congress may take to shore up the system, as under current rules its trust funds will empty in just over a decade. When those trust funds empty, Social Security will still be able to pay the majority of its benefits. In the absence of changes, however, the typical recipient should expect to see around a 20% cut in benefits, rising to 26% over time.
If you have a pension, your employer may be able to provide estimates as to what your benefit will be. Recognize, though, that like Social Security, your actual pension benefit will depend on the circumstances at the time you separate service and start collecting.
No. 5: Do the math to figure out how much you'll have to come up with
Essentially you'll take your existing costs, subtract out those costs that go away around retirement, add back in the new costs you'll face, then subtract your guaranteed income like Social Security.
The following table shows an example of how that math may work out.
Amount |
Purpose |
---|---|
$50,000 |
Current annual costs |
($18,000) |
Costs that go away around retirement |
$12,000 |
New costs you'll face in retirement |
($24,000) |
Guaranteed income in retirement |
$20,000 |
Annual amount you'll have to cover out of pocket |
With that estimate of how much you'll have to cover out of pocket, you can now get a handle on how much you'll need to save to cover those costs.
No. 6: Use the 4% rule to set your total retirement savings target
The 4% rule is a fairly common guideline in retirement planning circles. In essence, it says that if you keep a diversified and balanced portfolio, you can spend 4% of the initial value of your portfolio in retirement and adjust your withdrawals by inflation each year.
That guideline's back testing indicates that by maintaining your portfolio in that manner, there's a great chance that your retirement nest egg will last at least as long as your retirement will. While it doesn't provide a guarantee of success, it's a decent estimate worthy of building a plan around.
Using the numbers above, you'll need to cover around $20,000 per year. Using the 4% rule, that works out to a $500,000 nest egg -- which serves as a reasonable estimate for how much you'll need saved up to cover retirement.
Get started now
Regardless of where you are in your retirement planning journey, the sooner you get started, the more time you'll have to get yourself ready before you start that new phase of your life. That makes today a great day to start using these six tips to get yourself closer to being financially ready to walk away from work.