How much money do I need to retire?
7 August 2006This is a complicated question with different answers depending on how old you are, how much income you want, and who you ask. There are a couple of things to think about:
1) Inflation. Over time, you’ll need to spend more money each year of your retirement. Inflation usually averages 2 percent or so a year, and it will be eating away at your money. For younger people, you will need much more money than sounds like a lot today.
2) Do I want to draw down or not? Drawing down is reducing the amount of principle in your retirement funds. It lets you retire with much less because you’re essentially planning to spend all your money before you die. The downside is that if you live too long, you’ll hit a financial crunch and may be forced to cut your spending or go back to work.
3) Spending. How much do you want to spend each year as a “salary” in retirement? How much can you cut back? The general rule is that you’ll need 75% of your salary in retirement, because you tend to find yourself needing less money.
4) Other sources of income. If you plan on getting social security or working, you need less to retire.
So how can you figure out what your nest egg needs to be? There are a couple of approaches:
1) The Rule of 25. The Rule of 25 says you need to multiply the amount you want in your first year in retirement by 25, and save that amount. So if you want $50,000 a year, then save $1,250,000. That money will last you for awhile before inflation starts catching up, and then you’ll need to begin drawing down over time. It’s a pretty conservative figure and you’re unlikely to have any financial pain from it. You can factor in Social Security - if you’re older, you should have an idea what you’re going to get from the statements they send you. If you’re younger, I wouldn’t bank on it existing when you retire.
2) Half the rule of 25. This is an aggressive retirement that is much more risky. You do the same as above, but cut it in half - put that into an annuity that expires when you die, guaranteeing you a lifetime income (but meaning your kids inherit nothing). The problem is that you won’t have any extra money stashed away if something goes wrong. You also won’t keep up with inflation.
3) The Rule of 20. This is for younger people who are less sure of what conditions will be like 30 or 40 years from now. Even in pretty conservative investments, you can expect that you will earn a 5% return - so if you want to earn $50,000 a year, you need $1,000,000. Take your current income and double it. So if you make $25,000, your goal is $50,000 - a goal that reflects the reality that your salary is not going to stay the same for the next 40 years, it is going to get higher. Then multiply that by 20 - for a rough goal of $1,000,000 if you make $25,000 a year today. Because you’re younger, you’re going to have to adjust your goals as you age. Every five years, reevaluate. Has your salary increased more than you thought? Have economic conditions overall changed for some reason? Would you still be happy retiring on $50,000 a year? If not, change the goal.
4) Go use various retirement calculators to get a rough idea. All of them use different formula and none are exact, but you can test them out and get an idea of what you need:
http://www.banksite.com/calc/retire
http://www.troweprice.com/ric/RIC/
http://apps.nasd.com/investor_Information/Calculators/nasd/retirementcalc.aspx
Discuss this on the Free the Drones Forums here.
2 Responses to “How much money do I need to retire?”
March 8th, 2007 at 12:49 am
[...] Over on Free the Drones, we get some solid answers to an important question: How much money do I need to retire? [...]
February 21st, 2008 at 4:30 pm
Here is a better way to retire. If would like to retire in 5 years or less, you need to focus on 1 thing first, replace 100% of your income, so that you do not have to worry about how large your asset base is, or on what rate of return that you earn on the investments.
The problem that most people have is, they do not use proper asset allocation. They think that they are allocated, when in fact they are divirsified within those asset classes. What I am speaking of planning your investments with boxes, stars or names, is not asset allocation.
Asset allocation includes, stocks, bonds and cash, which are three of the 8 asset classes. Their primary job within the overall portfolio, is to stocks, (keep pace with inflation, bonds, (track or trail inflation), Cash (trail inflation). What you gain with only a three prong asset allocation is lowered return, but much greater liquidity.
If you focused on replacing your income through the other 5 asset classes, which historically have returned greater returns. By systematically replacing your pre-retirement income in chuncks, using total balance sheet and personal net worth focus.
The true definition of retirement is being able to replace 100% of your income in perputitiy. Being able to do this because your portfolio is properly allocated and your plan is now focused on your goals, not on return.
The key to retirment is retirement income replacement.
Best of luck,
Michael J. Fitzgerald, CPA/PFS, CFP, MST
http://www.fitzfp-llc.com