My father retired in 1991 after 39 years as a high school teacher. His pension, along with my mother’s pension and their social security checks, added up to more than they spent every month. Dad never had to ask himself whether he’d saved enough to retire. He simply needed to work enough years to get his pension. In 1991, most people with pension plans had traditional defined benefit pensions, pensions that paid a monthly income until you died. These days, most workers with pension plans have defined contribution plans, such as 401(k) plans. Workers own the money in their retirement accounts. But they have to figure out for themselves whether it’s enough to retire. How much retirement savings you need to retire is going to depend upon how old you are when you retire, how much social security you collect, what additional income you have in retirement, and how much you spend each year. Let’s look at an example of how to calculate retirement saving needs.
Jocelyn is 55 and single. Her annual total salary is $44,000 a year. She plans to retire on her 70th birthday. To estimate how much money she needs to save to retire at 70, Jocelyn first writes down her current annual spending by category. Your own categories may be more or less detailed than hers. Jocelyn goes through her financial records, including her checkbook and her credit card statements for the last year, to figure out how much she spent on what. On the W2 form that her employer sent her at the beginning of the year, she sees that she paid $3,366 in FICA and Medicare taxes. Her state and federal income taxes were $4,000. She contributed $6,000 to her 401(k) retirement savings. She funded her rainy day account years ago and didn’t add to it last year. Jocelyn’s employer currently pays for her medical and disability insurance. Her out-of-pocket medical expenses last year, including medications, were $1,000. Rent, $15,600. Phone and utilities, $2,400. Groceries, $3,600. She spent $1,200 eating out and $1,000 on entertainment and travel. Auto maintenance cost her $1,000, auto insurance, $800, and gas, $1,000. She spent $1,200 on clothing and personal items. Jocelyn spent $600 on gifts and gave $600 to charity.
Her renters insurance and other expenses were $634. Jocelyn now goes through her list and asks herself which expenses are likely to change after she retires. She won’t pay FICA and Medicare taxes after retiring. That’s one big savings. Her state and federal income taxes will be lower. As we’ll see, most of Jocelyn’s retirement income will be her social security benefits. And at Jocelyn’s income level, less than half of her social security will be subject to federal income taxes. After she retires, Jocelyn will no longer contribute to her 401(k) retirement savings account. However, she does plan to set aside $3,000 a year for unexpected expenses.
She will pay $1,500 a year for her Medicare Part B and D coverage. And her out-of-pocket medical expenses will likely increase as she ages. Jocelyn expects most of her other expenses to stay about the same after she retires. Two exceptions are that she’s going to spend less money on gas, since she’ll no longer be driving to work, and she plans to spend more on travel. All together, Jocelyn expects to spend about $37,134 a year after she retires. Jocelyn looks up her projected social security benefits on the Social Security website. If she starts claiming benefits at age 62, she’ll receive $11,700 in today’s dollars each year. If she claims at 67, she’ll get $17,556 a year. And if she waits until 70 to receive Social Security, she’ll receive $22,320 a year.
She’ll get nearly twice the annual income if she claims social security at 70 rather than 62. Jocelyn is healthy. And her mother lived into her 90s. Her biggest financial fear is that she might outlive her savings. Waiting until 70 to claim social security is one of the most cost effective ways to provide additional income in old age. And that’s what Jocelyn decides to do. Jocelyn will spend $37,134 a year in retirement and receive $22,320 in social security benefits. That leaves her with $14,814 to fund out of her retirement savings.
That’s in today’s dollars. When Jocelyn retires in 15 years, everything will cost more because of inflation. Fortunately, social security benefits are indexed to inflation. So her social security income will rise about as fast as her expenses do. However, in 15 years, she will need more than $14,814 to make up the difference between her social security and what she plans to spend. How much more? Over the last 25 years, inflation in the United States has been about 2.5% a year. If that trend continued, Jocelyn’s $14,814 in annual expenses will be about $21,500 in 15 years.
You can calculate that by multiplying 14,814 by 1.025 to the 15th power, which equals 21,455. Alternatively, you can use one of many future inflation calculators available online. Jocelyn decides to be a bit more conservative in her projections. And she assumes that her expenses will go up by 3% a year, not 2.5%. Let’s use an online calculator to see how much $14,814 will grow to in 15 years with 3% inflation. Enter the expected inflation rate of 3% a year for 15 years and a starting amount or a present value of $14,814. With inflation of 3%, Jocelyn will need about $23,000 a year in income beyond her social security when she retires in 15 years. So how much savings will Jocelyn need to provide $23,000 in income when she’s 70? In a video on spending in retirement, I suggest that people apply the RMD spending rule.
That is, each year spend no more from your retirement savings than the required minimum distribution mandated by the IRS. The rule can also be used to estimate how much savings you need to provide a level of income. To do so, look up the RMD withdrawal factor for the age at which you plan to retire. You can find this on RMD calculators such as the one on investor.gov. Or you can look it up on the IRS website. Multiply the annual income you’ll need by the withdrawal factor. And that gives you the amount of savings you’ll need to generate that annual income under the RMD rule. In Jocelyn’s case, let’s keep things simple and assume that her birthday is in January. Her RMD withdrawal factor the year in which she retires, also the year in which she turns 70 and 1/2, will be 27.4.
times $23,000 is $630,200. So Jocelyn’s going to need about $630,000 in savings plus her social security to support her anticipated expenses when she retires. Put differently, the year she retires, Jocelyn’s required minimum distribution will be 3.65% of her retirement savings. And $23,000 is 3.65% of $630,200. So that’s it. Estimate how much you’re going to spend in retirement. Subtract your estimated social security benefits from that, as well as any other income you’re going to have in retirement. And that gives you the expenses that you need to fund through your savings. Adjust these expenses for inflation between now and when you retire. And multiply by your RMD withdrawal factor the year that you retire. This will give you an estimate of how much money you’re going to need when you retire.
Of course, your situation may be more complicated than Jocelyn’s. For example, if you own your home and have a fixed rate mortgage, your mortgage expenses won’t increase with inflation and will end when you pay off your mortgage. So calculate future mortgage expenses separately from your other expenses. Furthermore, if you own your home this gives you additional savings. What if you plan to retire before 70? Required minimum distributions start the year you turn 70 and 1/2. If you are thinking of retiring a few years earlier, I suggest using a withdrawal rate of 33.
That is, multiply the annual expenses you’re going to need to cover from your retirement savings by 33 to get the amount of savings you’ll need. If you are planning to retire many years before you turn 70, you’re probably not watching this video. What if there is no way for you to save enough to fund the retirement you’d like? That’s a tough problem, but not an uncommon one. To have more income in retirement, wait until 70 to claim social security benefits. Also, consider working a few more years before you retire, looking for part time work after you retire, taking in a roommate, or reducing your spending. Planning for retirement is much harder today than when my father was teaching at Mahtomedi High School. The change from traditional defined benefit pensions to 401(k) retirement plans has shifted the responsibility and risk of funding retirements from employers to individuals. You have to decide how much to save, how to invest your savings, and how much you need to retire. This video may help you figure out the minimum you’ll need to retire. But you will continue to bear the risk that your investments do poorly or that you live longer than expected.
So if you possibly can, try to retire with more than the minimum. .
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How much money do you think you would need to be able to retire? It’s a question that a lot of people have asked their financial advisers and it’s one that seems to have a different answer for just about every time it’s asked. And the reason for that is simple the amount of money that you need to be able to retire depends entirely on how much money you think you can earn in retirement through interest and dividends and maybe even a part-time job if that’s your thing, and perhaps even more importantly how much money you’re actually going to need to survive in retirement. And that number seems to change each and every time you ask as well because projections of things like medical expenses change as time goes on. And I’m sure those of you who are nearing retirement watching this video know medical expenses just seem to be going through the roof, particularly for retirees. But that doesn’t really help us it doesn’t give us a goal to strive for as we’re going through our working careers. We may not be able to come up with an exact number that we’ll need but can we come up with something that’s at least going to be close? Well today I’m going to talk about something called the 4% rule and how it gives us that goal to shoot for.
I’m also going to be talking about some other factors to keep in mind when you’re using this rule of thumb as well as some situations where you’re going to want to avoid the 4% rule in entirely. Let’s get started. So what is the 4% rule? It’s a rule of thumb that’s used to determine the amount of funds that you will withdraw from a retirement account each year. It’s also sometimes called the safe withdrawal rate because the money you take out usually consists mostly of interest and dividends, and thus your principal either stays the same or goes down a little bit but not too much. In fact in 1994 a financial advisor named William Bengan did an exhaustive study of historical returns in the market focusing heavily on the severe Market crashes of the great Depression and the early 1970s and concluded that even during those hard Times no historical case existed where the safe withdrawal rate exhausted a retirement portfolio in less than 33 years.
And for most of us 33 years would easily cover our retirement. The idea behind the rule is that once you have approximately 25 times your annual expenses saved for retirement you should be able to retire with reasonable certainty that you could survive until death on your savings. Because at that point the amount that you take out for your annual expenses would be approximately 4% of your retirement savings. And when I say 4% of your retirement savings I mean your entire retirement savings anything that’s been earmarked to use only in retirement this includes 401ks IRAs and any other ways you’ve saved a nest egg for retirement.
For example if you had $450,000 in your 401k and $50,000 personal IRA then you would have $500,000 in all of your retirement accounts and your initial withdrawal on the first year retirement would be 4% of that $500,000 or $20,000. So some other factors that you’re going to want to keep in mind when using the 4% rule in addition to keeping an eye on your expenses, is to account for inflation. The 4% rule believe it or not actually allows you to increase the amount you withdraw to keep Pace with inflation. You can account for this either by just setting a flat 2% increase to your withdrawals each year which is the target inflation rate by the Federal Reserve or by just looking to see what the inflation rate was for the current year and adjusting based off of that. Now you might be wondering how this could possibly be I mean if you increase how much you would withdraw to keep up with inflation won’t you eventually run out of money? It’s a legitimate question but as it turns out no.
And it’s because over the long term the market goes up. Now there are a lot of numbers that are thrown around by financial advisors about how much the market actually goes up I’ve heard anything from 6 to 10% a year on average. I’m going to be conservative here and go with the 6% end of the scale. So let’s go back to the example I’ve been using in the video you start off retirement with $500,000 in savings, and in the first year of retirement you withdraw $20,000 or 4% of your savings. And I’m also using a compound interest calculator here, and it assumes that whatever you withdraw is withdrawn right at the start of the year.
So the $20,000 is going to be withdrawn on January 1st of every year. I’m only noting that because it makes it a worst case scenario you were to say withdraw $20,000 over the course of an entire year but you did it in installments of $1,600 each month you would be able to earn interest on the rest of the money that you hadn’t yet withdrawn throughout the rest of the year and thus you’re ending net worth would end up being a little bit higher than it will be in this example. So on January 1st you withdraw $20,000, meaning you only have $480,000 left in your nest egg. But over the course of the year the market goes up by 6% which means the value of your portfolio at December 31st would be $508,800. Now in year two of retirement you increase your withdrawal by 2%. So on January 1st of the second year of your retirement you withdraw $20,400. That brings your portfolio value down from $508,800 to $488,400. But again the market goes up 6%, which by December 31st brings the total value of your portfolio up to $517,704. If you were to continue to calculate this out for 30 years you’re ending net worth would be $787,716.90, almost $300,000 dollars more than what you started with in retirement! But of course this is just a rule of thumb so there are situations where you’re going to want to avoid using this all together.
One of those situations would be if your portfolio consists of a lot more higher risk Investments then say your typical index funds and bonds that are usually in a retirement portfolio. This is because obviously a higher risk investment can go down a lot faster than your typical retirement portfolios, which can be extremely devastating especially early on in retirement. Also this rule of thumb only really works if you stick to it year in and year out. And if you’re not going to be able to do that then you don’t want to use this as your retirement goal, because even violating the rule for one year to splurge on a major purchase can have a severe effect on your retirement savings down the road because the principal from which the interest and dividends that you get to survive is compounded from gets reduced. Let me give you an example of how this works: Say that in addition to taking out the $20,000 your first year in retirement, you decide to treat yourself with a new car and figuring that you’ll be traveling a lot during retirement you want to get one that’s good, big, and comfortable as well as reliable.
So for this example let’s say you get a new Toyota 4Runner for about $35,000. Now I know that you could probably find it for cheaper used, but not everybody likes to buy cars used I know my dad didn’t and besides this is just an example. So you drop $35,000 on a new car and you still have to have money to live so the $20,000 still does come out of your retirement, meaning that you only have $445,000 leftover. Now admittedly the market still does go up about 6% leaving you with a nest egg of $471,700 at the end of the year.
And even if you were to stick to the 4% withdrawal rate for the rest of retirement which, would be 30 years in this example, by the 27th year you would be taking out more than you earned an interest and dividends as well as how much the market went up. And by the 30th year of retirement you would withdraw $35,516, but with interest, dividends, and Market appreciation your portfolio would have only gained $33,209 in value.
And that could put you in a pretty dangerous position should the market go down for a couple years, or if you have some kind of medical emergency. Now I don’t want to make it seem all bad, I mean unless you retired early, after 30 years in retirement you’re probably in your 90s and don’t need the money to last very much longer and even in this example you still do end with $586,000. It could be worse right? However I do want to bring your attention to the difference that this made. This one purchase made your ending net worth that you could have left as inheritance to your children or grandchildren or even donated to charity go from $787,000 all the way down to $586,000, that’s a difference of over $200,000. And all that’s with just one splurge. But that’ll about do it for me I hope you enjoyed the video and if you did or if you learned something be sure to like And subscribe I’ve got a lot more of these Finance coming out in the near future as well as some more book summaries and other fun stuff.
But with that being said, thanks for watching and have a great day. .
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