How to Calculate Your Retirement Savings Needs

Laughing retired couple sitting in grass near two bicycles.
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One of the hardest parts of retirement planning is figuring out how much money you should save. According to the U.S. government, the three most common options are retirement plans offered by an employer, investments, and Social Security.

Many guides list goals that you should try to hit. Many experts say you should aim to replace between 70% and 85% of your pre-retirement income. In other words, your goal should be to create enough savings that you would be able to live on $70,000 to $85,000 per year if you earn $100,000 a year. People live an average of 20 years after retirement in the U.S.

Basing Your Needs on Current Income

Using your current income isn't helpful for people who are in the early stages of their careers. You're likely earning an entry- or mid-level income in your field if you're in your twenties or thirties. Your income might drop for a while if you make a career change. All this will affect your savings formula.

It becomes hard to project the amount you'll need during your senior years if you're unsure what your pre-retirement income is going to be over the years.

What If You're a Saver?

Another problem with the "replace your income" rule of thumb is that this advice assumes that you spend most of your income. It implies that you spend somewhere from 70% to 85% of your income if you save 10% to 15% for retirement, and perhaps another 10% to 15% for other non-retirement types of savings.

This approach assumes that you don't expect your spending habits to change at all during retirement.

It isn't always the case that people spend the bulk of what they earn. In fact, some spend more than what they earn, ending up in credit card debt, while others spend much less than the amount they earn.

This is another reason why basing your retirement projections on your former income (rather than your future expenses) is not the best framework for planning. 

Focus on Spending, Not Income

It's wise to base your retirement projections on your level of spending, not on your income.

The Bureau of Labor Statistics saw a 5.4% increase in income and a 7.8% increase in expenditures in their 2019 consumer report, before the financial effects of the 2020 pandemic. Transportation expenditures saw the largest percentage increase with a 10.1% rise. Spending on entertainment dropped by 4.2%, and spending on personal insurance and pensions fell by 1.8%.

Your spending in retirement will most likely not be the same as your spending today. You may not have a mortgage payment at that point in time. Your children may be grown and living on their own, so you'll no longer have to support them. Costs related to your work, such as childcare, business attire, and commuting costs, will also go away.

But you'll incur other costs that you may not have to support today. Out-of-pocket prescription and medical costs might become a bigger concern. You may also want to outsource home-related tasks that you currently do yourself, such as cleaning gutters, raking leaves, or shoveling snow. You may choose to travel more, or use your retirement to explore hobbies that you couldn't pursue during your working years.

Income isn't a perfect basis for determining how much money you should have in retirement savings. Expenses aren't a great option either. But expenses may be the best benchmark for how much you should aim to save. Some of your current expenses will decline, but others will grow, so it make sense to project that what you spend now will be at least close to what you spend during your retirement years.

Multiply Current Annual Spending by 25

Here's a broad rule of thumb that you can use to figure out how much money you'll need when you retire. Multiply your current annual spending by 25. That's what your savings will have to be in retirement to allow you to safely withdraw 4% of that amount every year to live on. 

You'll need an investment portfolio that's 25 times $40,000 a year—$1 million at the start of your retirement—if you spend $40,000 per year now. This sum allows you to withdraw 4% in your first year of retirement, and that same 4% adjusted for inflation every year going forward. You'll maintain a decent chance that you won't outlive your money. 

You could amass a $1 million portfolio even on a salary of only $30,000 to $40,000 if you begin saving at an early age, as early as your twenties.

If You Got a Late Start With Saving

Don't despair if you start saving later in life. The best way to make up for getting a late start is to save harder.

The older you are, the more you should be saving and diversifying for retirement each month. Don't over allocate a portion of your savings to stocks with the thought that you need riskier investments to make up for lost decades of savings. Risk cuts both ways. You won't have as much time to bounce back if your investments suffer.

Use index funds. Look for low-fee funds. Spread your money between a mix of stocks and bonds. Keep doing this through the rest of your working career with the goal of saving 25 times your current level of spending by the day you retire.

Use a retirement calculator to make sure you're on track. Ignore scary headlines in the financial news. You're playing a long-term game. Getting caught up in the daily ups and downs of the market will only curb your progress.

Focus on ways that you can either boost your income or lower your expenses if you're getting a late start saving for retirement. Doing a combination of both is ideal.

Redefine Retirement

The Bureau of Labor Statistics projects that the labor force will grow to about 164 million people by 2024. That number includes about 41 million people who will be age 55 and older—and about 13 million of them are expected to be age 65 and older.  

People are working later in life for many reasons. Consider a few options before you "officially" retire if you got a late start and need to earn more to make up the difference between what you need and what you have.

It could make sense to remain employed and take advantage of employer-matching contributions along with catch-up contributions to your 401(k) if you love your job. You'll get to keep your other benefits a little longer as well.

Use your decades of experience to work part time as a consultant for a few years while your money continues to grow.

Start a second career in an area you've always been passionate about. Embark on a new journey in a new field for a few more years if taking a pay cut lets you stay on track to meet your savings needs.

Redefine Your Lifestyle

Maybe you didn't get a late start with saving, but you just can't spare the extra change to build a portfolio that reflects your current level of spending. You might have to redefine what kind of lifestyle you want to live in retirement. There are plenty of ways to cut costs and maintain an active lifestyle.

It may make sense to downsize. Retire to a state with no income tax instead of keeping the home you own now. You could take it a step further and retire somewhere overseas where there's a lower cost of living.

There are plenty of ways to make retirement work. You just have to play with the numbers to see what makes the best sense for you. Save what you can even if you don't foresee a $1 million retirement portfolio, then adjust the habits that define your lifestyle.