Last month, we discussed the 5 key questions to consider when nearing retirement.  These covered the areas of health care, housing, lifestyle, and family.  This month, we’ll get down to the question of income, the next important part of this adventure.

The first part of this question is usually “How much money do I need to successfully retire?” 

Just like a question about what’s best for your health or your family, the answer is highly personal, and no one size fits all.

One way to answer this question is to use your age.  According to a widely used concept popularized by Fidelity, you should aim to have twice your annual salary saved by age 40; four times your salary saved by age 50; six times by age 60; and eight times by the age you want to retire (i.e., age 67).

In my experience, this method is interesting, but not particularly realistic because we tend to have our higher-earning years later in life.  While it is essential to get started saving for retirement as early as possible, goals such as paying off debt and growing a family take center stage earlier in life.  So, the math doesn’t always quite work out in alignment with your age, in my opinion.

Let’s look at this from a needs standpoint.  What if you ask: How much income do I need each month, to live the lifestyle I want to live?  The answer here lies in looking at your current budget.  If you haven’t done a budget checkup in a while, now would be a good opportunity.  (You can visit my post on “Three Different Ways to Budget” for a refresher.)  What you’re looking for here is the bottom line amount that you need to have in your bank account each month, after taxes.

Once you have that amount, next: think about where your retirement income will come from.  Do you have a pension?  A 401k?  IRA’s?  Other assets?  Will you include Social Security in the picture?

Start with your guaranteed sources first: pensions and possibly Social Security.  These are sources of income that provide an amount that won’t fluctuate, so they provide your “basement” or foundation.  Add them up, and then you can start your calculation like this:
“Amount I need” minus “Amount I will get from guaranteed sources” = ??

This number tells you how much you need your other resources to generate.

For example: I need $3000/month in my hand per month after taxes.  I anticipate I will receive $1000/month from Social Security.  That means I need my other sources (like my 401k) to generate $2000/mo after taxes (an important part!).

Now you can start to answer “How much should I have in my 401k?”

First, we have to deal with that pesky but very important tax question.  Your tax rate may change in retirement, so estimates here can be tricky.  For specific estimates contact your CPA.  For this example, we will use a 20% tax rate.  Then $2400 is the actual amount that your 401k needs to produce for you each month.

If you think of this like a car, what we just calculated is how much output we need from the engine.  Next, we can figure out how big of an engine we need to build.

A quick and simple way to do this step is to divide your need by an annual withdrawal rate.  Planners vary on what they consider to be a reasonable withdrawal rate, but most would probably land around 4%.  Why?  The idea here is to try to “live off the interest” so your money can keep operating in perpetuity.  You can use a higher rate of withdrawal, but if you do, you risk the possibility of your money running out before you do.

See Fidelity’s article about sustainable withdrawal rates here.

Using the previous example:
$2400/month need, including taxes, expanded to an annual number: $28,800

$28,800 divided by 4% annual withdrawal rate = $720,000

Quick answer: you would need $720,000 in your 401k to meet your needs.

Finally, a different way to come at the question is to work it backwards.  For example, if you are on track to have approximately $500,000 in your 401k by age 60, that could potentially generate $20,000 pretax per year.  If you use a 20% tax rate, that would mean approximately $16,000 in hand per year or $1333 per month.

Take a look at that, then ask yourself: can I live on $1333/month, given my other income sources?  (Don’t forget to add in what you expect to get from guaranteed sources and possibly Social Security.)

If this number is not feasible for you, then the question to ask becomes: what changes to my lifestyle or budget can I make today, so that that number becomes feasible?

As you can see, answering the “how much” question is multi-faceted and complex.  We’ve only looked at three possible methods here: using your age as a guide; using needs or expenses, and working it backwards.  I hope these calculations have helped you to think about your retirement readiness.  These are only examples to get you started thinking and do not include other factors that could affect your retirement equation such as inflation.  If you have questions about your particular situation, please send me an email!  I’m here to help.

Shadowridge Asset Management, LLC does not offer tax planning or legal services, but may provide references to accounting, tax services or legal providers. They may also work with your attorney or independent tax or legal advisor.