Most of us would be well served by a retirement calculator, which can help us plan how much to sock away in order to meet our retirement goals. There are gobs of retirement calculators and other financial calculators on the Internet. A handy and easy-to-use one I like is Moneychimp.com. It's called a compound interest calculator, but it works just fine for retirement number crunching, too. Instead of an interest rate, plug in your expected growth rate, and you're off to the races.
Let's run through an example -- one that's forward-looking, taking your estimated contributions and showing you how much you can amass. Let's assume that you're 45 and have no savings yet, but plan to sock away $5,000 annually for 20 years, until retiring at age 65. We'll also assume you expect to earn the stock market's long-term annual average growth rate of close to 10%.
With the Moneychimp calculator, you'll enter 0 in the "current principal" field, as that's where you'll note how much you've already got in your investment account. Your "annual addition" is $5,000 and "years to grow" is 20. You can leave the compounding rate as once a year, and then all you have to do is click the "Calculate" button: Presto, $315,000!
The beauty of a retirement calculator is that you can play around with different scenarios. If you think $315,000 won't be enough for you, see what socking away $7,000 annually will do. It turns your projected nest egg into $441,000.
If you already have one or more retirement accounts with money in them, enter that total in the "current principal" box, and you'll see that it makes a big difference, if it's growing at 10% for 20 years. Simply starting with $25,000 and then adding $5,000 annually for 20 years can build a future value of $483,000.
You can work backward with a retirement calculator, too. Let's say that, Social Security and other fixed-income streams aside, you want to build an income of $30,000 per year from your investments. Here's where the rough rule of thumb to withdraw 4% of your nest egg each year comes in. Four percent of something is the same as taking 1/25th of it. Since you want $30,000 to be 1/25th of your investment account, you can multiply it by 25 to see how big a nest egg you need in order to generate that $30,000 as a 4% withdrawal. Multiply $30,000 by 25, and you'll get $750,000.
Now visit the retirement calculator and try plugging in some different annual savings numbers. With zero current savings, 20 years until retirement, and 10% estimated annual growth, a yearly investment of $10,000 will get you to $630,000 -- less than you need. Try $11,000, and you'll get $693,000. Now try $11,500, which gets you $725,000. Finally, increase your annual contribution a bit more to $12,000 and you'll end up with $756,000. Bingo.
It's worth keeping inflation in mind when you crunch these numbers, as it can shrink the buying power of your future dollars.
Here's a handy short-cut: Since inflation has averaged about 3% annually over long periods, you can reduce your expected annual growth rate by that much in order to get inflation-adjusted results. In our examples above, we used a 10% estimated growth rate. Lop three percentage points off that and you get 7%. Now run your calculations through the calculator using 7%, and you'll see that your eventual nest egg won't be worth quite as much as you expected.
In our last example, where we found that annual investments of $12,000 growing at 10% for 20 years will grow to $756,000, we can change the 10% to 7% and see that the result is $526,000. The actual amount your money would grow to is still $756,000, but by factoring in inflation, you can see how much purchasing power that will give you, in 20 years, if inflation averages 3%. That's because food, fuel, cars, and most things will cost more then.
Finally, remember that the 10% we used in the examples above may be the stock market's long-term average, but it doesn't mean you'll average that much over your 20 years. You will likely average more -- or less. Thus, it's smart to be conservative in your modeling. If annual investments of $8,000 will get you to your goal at 10% growth, try plugging in 8% growth and see how much you will amass. Then see how much more you would need to sock away each year to amass the sum you want if the market grew at a slower pace.
If you're splitting your nest egg between stocks and bonds, an overall 10% growth rate is unrealistic to begin with, as bonds will generally grow more slowly than stocks. Crunching numbers with a calculator can help you see whether your current system is on track to amass as much money as you expect to need. You might find that you need to be a bit more aggressive in your saving, or in how you invest that money.
When it comes to planning for retirement and figuring out how much you should sock away, don't neglect to consult a retirement calculator, as it helps you see how effectively your plan will work.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.