You know how important it is to save for retirement. But how can you determine exactly how much money you’ll need for your after-work years?
Unfortunately, there’s no magic formula. How much you’ll need to save depends on everything from your health, to the lifestyle you want to live, to how long you can stay in your current home. And it’s not easy to predict these variables.
That’s why we gravitate toward retirement formulas, simple mathematical equations that can at least help us in determining the amount of money we’ll need in our nest eggs once we’re no longer working. Two of these popular formulas are the “4% Rule” and the “Multiply by 25 Rule.”
Both formulas can help you calculate the amount of money you’ll need to save and how much you can afford to spend each year in retirement.
But here’s a warning: Neither of these formulas will tell you exactly how much money you’ll need. Blindly following them could lead to a retirement in which you can’t afford the lifestyle you want to lead. That’s why financial and retirement-planning experts say that these two rules are only general guidelines and are no substitute for in-depth retirement planning.
Josh Littauer, founder of Financial Fitness, based in McKinney, Texas, suggests that when planning for retirement, you need to look carefully at the type of lifestyle you want to live in retirement. He says that will be more useful than relying on standardized retirement formulas.
“What lifestyle do you want to live in retirement?” Littauer asks. “Do you have a large house? Do you travel often to see kids? Are you a member of a country club? These are all questions to start asking. You can then look at your current income and see whether it needs to stay the same or increase to meet those scenarios.”
Here’s a look at these two rules and how they work.
Multiply by 25
The Multiply by 25 Rule is fairly simple: To determine how much money you’ll need in retirement, multiply your hoped-for annual income by 25.
Say you plan on withdrawing $50,000 from your retirement savings each year. Multiply that $50,000 by 25 to determine how much you’ll need. In this case, it comes out to $1.25 million. If you only expect to withdraw $30,000 a year from your retirement nest egg, you’d need $750,000 in retirement savings.
Keep in mind that this rule doesn’t factor in other sources of income during your retirement. If you are earning Social Security or rental income, for instance, the Multiply by 25 Rule doesn’t include this extra income.
The 4% Rule
The 4% rule is one you follow after retirement, not while you’re saving money for it. According to this rule, you should only withdraw 4% of your retirement savings every year once you’ve left the working world.
Say you have $1 million saved for retirement. In your first year of retirement, you should withdraw no more than $40,000, or 4% of $1 million.
You should then withdraw that same amount every subsequent year of your retirement.
Brandon Renfro, a professor and financial planner based in Hallsville, Texas, blogs frequently about retirement planning at brandonrenfro.com. He says that the 4% rule can be helpful to people nearing retirement. This doesn’t mean, though, that withdrawing 4% from your retirement savings each year is always the best choice.
“Too many people blindly follow the 4% rule,” says Renfro. “It’s much better to think of it as a method of analysis rather than a conclusion.”
The 4% rule assumes certain things, Renfro continues. The rule assumes that you are planning for a retirement of 30 years and that your retirement savings consists of U.S. Large Cap Stocks – money invested in large firms that have a market capitalization of more than $10 billion – and intermediate bonds.
If your retirement doesn’t follow this formula, it might make sense to withdraw more or less than 4% each year, Renfro says.
For instance, if you only plan on a 15-year retirement, you might decide to withdraw more than 4%, whereas, if you think your retirement will last 40 years, you should withdraw less.
The key, though, is to work with a retirement planner to determine the best withdrawal amount for your retirement and to reassess your plan on an annual basis to make sure that you’re not draining your retirement funds too quickly.
Michael Alexenko, president of Royal Asset Managers, based in St. Charles, Illinois, says the true key to calculating how much you’ll need for retirement is to look carefully at your current spending habits and then determine how this spending might change after you leave the work world.
Alexenko recommends that you track your expenses before you hit retirement so that you can create an accurate household budget. He says tracking your expenses carefully for six months should provide you with a good average monthly spending rate.
Once you outline this budget, you can estimate how your spending will change in retirement. Alexenko says that transportation costs might fall in retirement because you will no longer commute to work each day. But your spending on meals and entertainment might increase because of the additional free time you’ll have.
“If you don’t need to leave much of a residual estate behind, then your spending rate can be higher,” Alexenko says. “But if you have good health, you have to plan for a longer retirement, which means a bigger nest egg or controlled spending.”
One Other Consideration: Senior Living
Arthur Bretschneider, chief executive officer and founder of Seniorly, a San Francisco-based senior living marketplace, works with families when they are searching for senior living options. He knows just how expensive retirement can be, and advises people to save as much as they possibly can before they leave the working world.
Unexpected expenses often pop up during retirement. Maybe you’ll fall and break your hip. Maybe you’ll need memory care services. Even if you’ve lived a healthy life, and you focus on diet and exercise while you age, you might still face costly medical expenses.
Bretschneider says that people are living longer, too. That makes it more challenging to plan for retirement, and is another reason to be more aggressive in your savings, even if formulas such as the Multiply by 25 Rule have you feeling comfortable about your retirement planning.
“We all age differently,” Bretschneider says. “Something can happen that changes retirement for you. You have to plan ahead for those variables. If you can set certain funds aside, you can have good outcomes as you grow older and avoid some of the pitfalls associated with being unprepared.”
How do you plan on making the most of your retirement savings? Let us know in the comments below!
If so, subscribe now for tips on home, money, and life delivered straight to your inbox.