There are a lot of sites that help you determine how much you need to save for retirement, but I have never been comfortable with them because they usually don’t share the logic behind their calculation. Also, there are critical three numbers you need (A) how much money you need per year, (B) how much you should have in your retirement account, (C) the percentage of your income you need to save. To help double-check the calculator, here are some steps you can follow to do your own calculations.
These steps do not take into account all the caveats unique to your situation; however, the method offers a good starting point for your retirement planning.
(A) How Much Money You Need Per Year at Retirement
1. Start With Your Current Yearly Expenses
If you think about what you’re able to live on today, you can figure out approximately what you can live on in the future (in today’s dollar)
You will likely spend less on:
- Saving for Retirement – Let’s pretend that you make $50,000 per year and save $10,000 a year for retirement. When you retire, you don’t need to save $10,000 a year anymore, so you could potentially live on $40,000 per year.
- Housing – If you are a homeowner today, there is a good possibility that you won’t need as much money for housing. For example, our escrow (insurance and taxes) is about 30% of our total monthly payment. By the time we retired, the house would be paid off and our housing expenses reduced by 70%.
You will likely spend more on:
- Medical Expenses – As you get older, you tend to spend more on medical issues, or you might be paying for your own insurance instead of participating in your employer’s plan.
- Extracurricular Activities – Working all the time doesn’t leave a lot of time for you to spend money on activities and travel. When you retired, hopefully, you will be in a better position to spend some quality time traveling and doing activities.
Let’s assume everything balances out, and you can live on $50,000 a year income.
The 80 Percent Rule for Retirement
There is a popular rule of thumb among financial planners that estimate your retirement income equal to 80% of your current income will give you a standard of living that is substantially similar to what you are experiencing now.
You can also use this rule to quickly determine your retirement income amount. However, we went further in-depth and show you how to calculate your percentage more precisely.
2. Adjust for Inflation
Now we have to adjust that $50,000 for inflation. According to the Bureau of Labor Statistics, the average inflation rate for the past 30 years has been about 3% (I am approximating the value based on the chart). So we can calculate what we need in…say 30 years with the following formula:
Retirement Income = Today’s $ * ((1 + inflation rate)^ Number of years to retirement)
Retirement Income = $50,000 * (1.03 ^ 30)
Retirement Income = $121,363
This means you’ll need about $121,500 in 30 years (inflation-adjusted and rounded up).
You can also use a Future Value Calculator, like this one on Investopedia.
(B) How Much You Need to Save for Retirement
1. Account for Other Income Sources
Remember that your retirement saving is not your only source of income. If you anticipate other income sources, you subtract these amounts from your Retirement Income number. For example, let’s assume you anticipate the following income:
- Social Security Income = $20,000 (according to SSA.gov, your social security retirement benefits replaces about 40% of your average earnings.)
- Pension = $15,000
- Rental Income = $25,000
You can subtract the $60,000 total of these other income sources from $121,500; therefore your retirement saving needs to generate $61,500 per year.
2. Calculate Target Retirement Saving
Using The Multiply By 25 Rule and the 4 Percent Rule, you can continue your calculation and determine how much you need to save. This is ideally how much you should have in your retirement savings right when you are getting ready to retire.
Target Retirement Savings = Adjusted Retirement Income * 25
Target Retirement Savings = $61,500 * 25
Target Retirement Savings = $1,537,500
You need to save about $1.5 million to begin retirement!
Well, don’t fall off the chair just yet…
Using this Investment Calculator at Calculator.net, you could potentially save $1.5 million in 30 years by investing ~$900 a month in the Stock Market (assuming 9% annualized return). This $900 a month represents about 21.6% of your income, so you do have to hustle a bit to get there.
(C) What Percentage of Your Income to Save for Retirement
Now that you figured out how much income you need when you start retirement, and about how much you need to save for retirement, let’s figure out what percentage of your income you need to save for retirement.
You could use the number you calculated in Step #2 and the Investment Calculator at Calculator.net to repeat the process above to determine what you need to save each year. You’ll have to play around with the numbers a bit to get it right.
I’ve put together a spreadsheet to help you with the calculation to make it easier for you.
In fact, the spreadsheet shows the numbers that we have been using in this article all along.
Start Saving Sooner
The above scenario above assumes you have 30 years to save, what if you start sooner?
- Start at 20 with 45 years to invest, you only need to save 11.26% of your income.
- Start at 25 with 40 years to invest, you only need to save 14.00% of your income.
- Start at 30 with 35 years to invest, you only need to save 17.16% of your income.
Comparing Against Online Calculators
Vanguard Retirement Income Calculator
I entered the same numbers as our scenario in the Vanguard Retirement Income Calculator and got the following result.
The main issue I see with Vanguard’s calculator is that it doesn’t adjust for inflation — so you might be falling short by the time you hit retirement age.
SmartAsset Retirement Calculator
You can also use the SmartAsset Retirement Calculator below. Again, I entered similar numbers in their calculator. The good news is that this one considers inflation (you can make more adjustments with the full version Retirement Calculator).
SmartAsset calculates retirement income requirement at a much higher amount of $169,560 per year, yet it indicates that we only need to save $552,178 because they are assuming you have other sources of income such as Social Security, pensions, savings and investment drawdowns (whereas we don’t in our calculation).
It is nice to be able to search online and plug in the numbers to see what you need for your retirement savings, but I think it is vitally important that you understand how to calculate the numbers on your own because each calculator uses a different set of rules and assumptions. If you don’t try and compare several different calculators, you might be led into a false sense of security that the numbers presented are good and accurate.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.