How Much Money Do You Really Need to Retire?
“When can I retire?”
“How much money will I need?”
These common questions are asked by millions of people grinding away at their jobs. The concepts are not taught in school and therefore are not common knowledge. Many people have no idea where to even start.
The two questions are intimately related – If you have no idea how much you need to retire, you will never be able to figure out when you can retire.
The good news is that after reading this post, you should have a reasonable estimate of how to answer the question of “How Much Money Will I need?”. Based on the answer to that question you can begin to figure out how long it will take to reach that goal.
You can determine how much money you will need to retire by following these three simple steps below.
Step 1: Quantify Your Current Spending
The first and most important part of making this determination is to figure out how much you spend. This sounds like a simple task and many people think they have a good idea of how much they are spending or intend to spend (via a budget), but it can often turn into an eye-opening experience when you see how much you are actually spending. The method you choose to track your spending is up to you, but the easiest ways are to either review your credit card statements or sign up for a free budgeting tool that automatically tracks your spending, such as Mint.com or PersonalCapital.com. If you pay mostly cash for things, it’s a bit more of a manual process but it can also be done with an excel spreadsheet or plain old pen and paper.
Some categories are easy to underestimate how much you spend, including restaurants, entertainment, etc. In addition to that, it can be hard to remember expenses that don’t happen every month, such as travel, insurance, gifts for the holidays, etc. For these reasons, it is ideal to look at a full year worth of spending and average the number over 12 months. If you don’t have the ability to go back a full year, go back as far as you can and average the number to get a starting point until you can get a full year of data. This number is something you will want to review each year to make sure your expenses are not drastically increasing, or at the very least make sure you understand why and if you can afford it if they are.
This number may shock you, but at this point of the process don’t be too quick to make judgments about whether your spending number is too high or too low. We can come back to that later.
Step 2: Adjust for the Lifestyle You Want to Live
Think about your current lifestyle and consider what lifestyle you want to be living when you are no longer working. Are you doing everything you want to be doing? Do you have additional expenses that you are expecting once you stop working? Remember that when you are no longer working you will have more time on your hands to spend money. Also don’t forget to include costs like health care that you may need to start paying for with out of pocket money.
Based on these considerations, add categories to your current spending and recalculate the yearly spending amount based on your desired lifestyle and spending.1
Step 3: Calculate Nest Egg Requirement
Now that you have a reasonable idea for how much you spend in a year, using the 4% rule of thumb2 we can calculate the lump sum nest egg that you will need to retire. For a full explanation of the 4% rule, see our blog post about it here. For the purpose of this post, the important thing to know is that the 4% rule states that every year you can safely withdraw around 4% from your investment accounts (adjusting only for inflation after the first year) and never run out of money. The concept is that if your nest egg is invested in a reasonable 60/40ish mix of stocks and bonds, the investment returns after inflation adjustments will outpace the amount that is being withdrawn.
If the safe amount that you can withdraw from your account is 4%, then in order to have enough money to quit you would need 25 times your yearly spending amount. For example, if you have a million dollars in your investment accounts, you could withdraw $40,000 per year ($1M x 0.04). Or, if you know you spend $40,000 per year, in order to indefinitely have enough money you would need a million dolllars ($40,000 x 25) in your retirement account.3
Reflect On Your Spending
Now that you’ve seen the amount you need to retire, you may be feeling excited about the future. Maybe you’re almost there! Or, maybe you’re feeling hopeless, like you’ll never achieve that goal. Before you get too down on yourself, there are some simple ways that you can drastically reduce that number and therefore how long it takes you to get there.
Reduce Spending
Looking back at the first step, were you surprised by how much you are spending? If the total number shocked you, it’s time to start digging into the details to figure out where your money is going. You may find that you spend $600 per month on going out to lunch or $1000 per month on bottle service or $800 per month on car payments. Remember that very few expenses in life are essential and many are discretionary and can be adjusted by you. This is where you need to determine what is important in your life and figure out where you want your money to go.
Everyone’s priorities are different and it’s not anyone’s place to judge others for what they spend money on. But this part is all about choice, and the more you can reduce your spending the quicker you will reach your goals. By spending less and saving more, you have more money to invest. But additionally, for each $1000 you can reduce your yearly spending, your required retirement nest egg goes down by $25,000. So spending less money exponentially reduces the time required to meet your nest egg goals. Who knew that saving $80 per month could have such a drastic effect on you long term goals?
Partial or Mini Retirements
Retirement doesn’t have to be an all-or-nothing concept. If you have a good chunk of money saved up but you aren’t quite to your goal, this doesn’t mean that you have to suffer through a soul sucking job for more years to reach your goal. You could take a mini-retirement or you could decide to get a part time or lower paying, but less stressful, job to supplement the portion that your investment accounts can’t cover.
Looking back on our previous example, let’s say you need $40,000 per year to cover your spending. Based on the 4% rule, you would need a million dollars to retire. What if you only have $500,000? With $500,000, you could safely withdraw $20,000 per year. Maybe a less stressful job would pay the additional $20,000 to supplement the shortfall each year.
Conclusion
It can seem pretty daunting to know just how much money you need to retire, but it doesn’t have to be. Using the 4% rule of thumb, you can get a pretty good idea of whether you are on track for a successful retirement and how long it will take you to get there. If you don’t have enough now or feel that you will never have enough, there are still ways to reduce the time required to get to your goals and hopefully even improve your quality of life while you’re getting there.
Additional Reading
While it is true that following this rule of thumb will give you a close estimate of your retirement nest egg goal, there are some things to consider when applying the rule, so we highly recommend that you read this post here.
In addition, once you get closer to pulling the plug on working, you will want to make sure that you have a decent emergency fund set aside. Life can throw some unexpected expenses at you, and without proper reserves you might find that your retirement funds don’t stretch as far as you hope.
Disclaimer: This article is intended to be a general resource only and is not intended to be nor does it constitute legal or professional advice. Any recommendations are based on personal, not professional, opinion only.
Footnotes:
(1) – If your retirement is many years away, you won’t be able to use today’s spending as your spending in the first year of retirement. You will need to consider an inflation adjustment for your yearly spending amount. Once you start withdrawing money, the 4% rule includes adjustments for inflation, but to get the starting withdrawal amount, you will need to make that adjustment. For example, if your retirement date is 10 years in the future and inflation is 3% per year, your future yearly spending would be:
Future Spending = Today’s Spending x (1 + 0.3)^10
(2) The 4% rule is referred to in this article as a “rule of thumb” because, while it is a widely accepted number to use as a safe withdrawal rate, there are criticisms of the rule. Some people argue that withdrawing 4% from the accounts without monitoring and considering market conditions is overly aggressive and could put the retiree at risk of running out of money. Others argue that in the majority of cases, 4% is an overly conservative withdrawal rate and the retiree could end up with more money than when they started. For the purpose of this post it is meant to give the reader a good estimate for where they stand in meeting their investment goals. If you are more on the conservative side or considering an early retirement, you could consider a slightly smaller withdrawal rate (like 3.5%).
(3) Age restrictions and tax implications of withdrawing money from various investments accounts have not been considered for the purpose of this post. There are many strategies used to legally reduce taxes and withdraw money from age restricted accounts if you are pursuing early retirement, but they are beyond the scope discussed here.