How Much Do You Need To Retire?

A Way to Quickly, and Roughly, Calculate Your Retirement Needs

Man raking up piles of money banknotes
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If you are like many men and women, you don't want to work for the rest of your life.  You save money.  You invest in a 401(k) plan.  You put funds aside into a Roth IRA.  Still, you wonder: How much do you need to retire?  Is there a magic number; a specific net worth or level of monthly passive income from dividends, interest, and rents?  To help you develop a general idea or ballpark figure, here is a back-of-the-envelope rough estimate technique to help you the next time you sit down at the kitchen table and examine your personal finances.

 It is far from precise but it can get you in the general area so you are better equipped to sit down with a registered investment advisor.

1. Start By Deciding How Much After-Tax Monthly Income You Need

The first step to knowing how much you need to retire is to develop three scenarios.

  1. How much do you need to survive with the bare minimum standard of living necessary to feed, clothe, and shelter yourself?
  2. How much do you need to enjoy a comfortable, middle-class standard of living?
  3. How much do you need to have a no-holds-barred dream retirement with everything you've ever wanted?

Run the figures.  Calculate housing costs, transportation costs, medical costs, spending money, food costs, travel budgets if there were a genie that would deposit the cash in your checking account each month based upon each of the three scenarios, how much would it need to deposit?  That's your starting point.  For every investor, these figures are going to be different.

 (Some have lived through poverty and know you can survive on a debt-free $40,000 house in a suburb of Kansas City, growing your own vegetable garden and eating healthy for next to nothing while riding your bike everywhere on $2,000 a month.  Others have never seen the world outside of a place like Greenwich, Connecticut and cannot fathom such a thing even being possible.

 That's okay for now.  Use your own frame of reference.)

2. Adjust The Three Scenarios for Your Estimated Effective Tax Rate

The cash you need for those three scenarios is spendable, after-tax cash.  That means we have to "gross up" the figures you just calculated.  This involves estimating your effective (not marginal) tax rate.  It can be tricky but you generally need to know where you think your money will originate.  If it's all coming from tax-free municipal bonds, no adjustment is necessary.  If it's coming from qualified dividends on stocks, you might pay anywhere from 10% to 23.8% plus state dividend tax rates in some cases.  If it' will be withdrawn from a SIMPLE IRA or another such retirement account, you are going to need to estimate your effective tax rate on ordinary income as if you were to go out and get a job.  The same goes for if you actually go out and get a job, selling your time and skill set for cash.  For most Americans, it's probably safe to estimate an effective combined tax rate of 25% though this is probably insufficient if you are wealthy and don't have a lot of tax shelters in place (good early planning can make up for a lot down the road).

To illustrate, imagine Scenario #2 from the first step was $7,000 per month.

 You estimate you'll have an effective tax rate of 25%.  In this case, you'd take $7,000 and divide it by (1-0.25), or 0.75, to get $9,333.  If your answer to Scenario #1 was $3,000 per month and you estimated an effective tax rate of 18%, you'd take $3,000 and divide it by (1-0.18), or 0.82, and get $3,659.

3. Take Each Gross Scenario and Back Out Known Sources of Income

The next step in discovering out how much you need to retire is to take all of the known sources of income you are fairly certain will be there for you, then back them out of the gross numbers you just calculated.  The two most common are 1.) pension benefits, and 2.) Social Security benefits.  (You can request the most recent copy of your projected Social Security benefits online after answering personal security questions to verify your identity.)

If your gross income needs from the last step were, say, $6,500 per month, and you expected to collect $1,800 per month from your Social Security check, $560 per month from your pension, and $1,350 per month from your spouse's Social Security check, that only amounts to $3,710.  You have a projected monthly shortfall of $2,790.  You'd need to figure out how much you could expect to earn from a part-time job or side-business activity.  Perhaps you could earn $400 a month from employment.  You're still $2,390 short.

4. Determine How Much Investment Capital It Will Take to Fund Any Shortfall

At this point, you have a general idea of how much you're going to find missing from the checking account each month.  You're either going to have work even more (if possible - it's not exactly easy for some people as their body ages), earn more money (if possible, some people don't have the education, skill set, or personal characteristics to increase earning power late in life by substantial amounts), or have more capital in your portfolio to generate income.  You might also have to consider different asset classes.  Case in point: One reason elderly American investors prioritize real estate investing over other forms of investing is that it overwhelmingly favors current income over long-term growth unless you are operating in a niche market at a time when some interesting economic forces are unleashed (e.g., San Francisco prior to the introduction of rent control (the surest way to destroy the poor and middle class, and enrich landowners, is to pass rent control; it's one of the most basic lessons freshman economic students, liberal and conservative alike, are taught) and interest rates going off a cliff).  In the Midwest, at the moment, you can still easily earn 7% to 10% cap rates on reasonably valued, smaller properties.  Paid for entirely in cash, you could extract around 6% per year while still maintaining the quality of the asset.  In a situation such as the one we just discussed - a $2,390 monthly shortfall, which equals a $28,680 annual shortfall - it would only take $478,000 in additional real estate holdings above and beyond both Social Security checks, the pension check, and a $400 a month part-time job to fund your lifestyle while leaving the entire amount behind as an inheritance for your loved ones or charity.

If you were willing to spend your estate down to nothing, you could probably get away with as little as $284,000 assuming a life expectancy of a dozen years or so.  Sure, you'd start pinching pennies toward the end but it wouldn't be a disaster unless you lived to be 90 years old or something (which, in the big picture, is not exactly a tragedy, all things considered).

Final Thoughts About Knowing How Much You Need to Retire

The heart of the matter is figuring out how much after-tax cash you need each month, grossing it up based on your estimated effective tax rate, and then breaking down where, specifically, that cash flow is going to originate.  Doing this will give you a fairly stark idea of just how prepared you are for retirement.