How much should you save for retirement?

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Saving for retirement can be a balancing act. On the one hand, you want to ensure that you have a comfortable retirement and don’t outlive your money. On the other hand, you don’t want to sacrifice so much in your working years that you don’t enjoy life. How to strike the balance?

Answering that question is further complicated by all the potential variables:

  • How long will you need your retirement account to last? The longer you need your money, the more you’re going to need.
  • How long do you have until retirement? The longer, the better, because you have more time to amass money.
  • What kind of investment returns can you expect? The higher your returns, the less money you’ll need to save or invest in the interim.

That list of questions could have many different answers, depending on your situation. Plus, a lot can change between now and retirement. Markets go up and down, for example, so it can be difficult to get a real gauge on any of these variables. We’ll need to make reasonable assumptions about what you might expect and then you can make adjustments as life changes.

Almost regardless of your life situation, you’ll have to save money to have a comfortable retirement. Here’s how to start saving and what steps you can take at each decade of your life.

Here’s how to run the numbers on your own retirement savings and what you need to know.

Retirement’s 4 percent rule

One of the traditional rules of thumb about how much you should save for retirement is called the 4 percent rule. The idea here is that you should draw down no more than 4 percent of your retirement account in a given year, so that you can make your assets last over your retirement.

While the rule has received some criticism for being less conservative than some advisers think it ought to be, it’s still a well-tested guideline that provides you a ballpark estimate of what you can safely harvest from your funds. You can use this rule to work backward to reveal the amount you need to save for retirement: You multiply the money you need each year by 25 to figure out the total amount you need.

For example, if you want $10,000 in retirement money annually, then you’ll want about $250,000 in funds. But here’s the catch: you don’t have to have all the money right when you retire — if you can generate returns on your investments. Here’s why return is so important to retirees.

Why you need returns

For example, if you had cash sitting in an IRA and earning almost nothing, you could take out $4,000 in year one ($100,000 * 4 percent), $3,840 in year two ($96,000 * 4 percent) and so on. If you’re not earning much or anything on your assets, your withdrawal declines over time. You eat into your principal quickly and take it down every year, hurting how much you can withdraw in future years.

Now, if you were earning even 4 percent on your money, you arrest that decline substantially. You could take out $4,000 in year one, then earn 4 percent on your investments. At the start of year two, you have a 4 percent return on your remaining principal for a total principal of $99,840, or $96,000 plus $3,840. So in year two, you can withdraw another 4 percent, or $3,993.60.

By investing in a 4 percent return, you’ve drastically pared how much principal you’ll have to take in any given year. Your 4 percent return is almost fully replacing the 4 percent you’re withdrawing each year and you still leave the principal mostly intact.

Now imagine you could earn a 6 percent return on your assets, while withdrawing only 4 percent. With the same $100,000 principal, you’d take out $1,000 in year one as usual. Then you’d have $96,000 and earn 6 percent, giving you $101,760. In year two, you could withdraw $4,070 and then $4,142 in year three and so on. You can actually grow your payout over time.

Once you earn a return higher than your withdrawal rate, you may actually grow your retirement account. The key ratio to keep an eye on is your investment return relative to your withdrawal rate. So the secret is to reduce your withdrawal rate or increase your investment return.

Tax-advantaged retirement accounts such as a traditional IRA or Roth IRA can amass money at an increased rate by helping you avoid taxes. Employer-based retirement accounts such as a traditional 401(k) or Roth 401(k) can also protect your investments from taxes.

How to get a 4 percent or better return

If you’re looking to clear that withdrawal hurdle of 4 percent, one way to do so is by owning the Standard & Poor’s 500 index, a broadly diversified collection of hundreds of America’s best companies. Over a 20-year period ending in 2019, the index raised its dividend by about 6.4 percent annually, nicely above what you’d need for the standard withdrawal strategy. Just as important, the index increased in value about 10 percent annually over long stretches of time.

Here’s what a $100,000 portfolio might look like over 10 years, assuming an average annual increase. The S&P 500 pays around a 2 percent dividend yield over time, so let’s start there.

Principal Withdrawal Annual dividends Capital gain Ending balance
$100,000 $4,000 $1,920 $9,792 $107,712
$107,712 $4,308 $2,068 $10,547 $116,019
$116,019 $4,641 $2,228 $11,361 $124,966
$124,966 $4,999 $2,399 $12,237 $134,604
$134,604 $5,384 $2,584 $13,180 $144,984
$144,984 $5,799 $2,784 $14,197 $156,165
$156,165 $6,247 $2,998 $15,292 $168,209
$168,209 $6,728 $3,230 $16,471 $181,181
$181,181 $7,247 $3,479 $17,741 $195,154
$195,154 $7,806 $3,747 $19,109 $210,204

This chart shows the starting balance of $100,000, your withdrawal amount, the dividends you earn on the post-withdrawal balance, and the ending balance, which factors in the withdrawal and the dividends and then adds in the market’s 10 percent growth rate.

You can look at the withdrawal column to see the money you could take out at a 4 percent withdrawal rate. That amount continues to go up annually even as you withdraw money. Importantly, you’re actually increasing your account’s total balance.

So having some growth investments even in retirement can help your money last longer, maybe even indefinitely if you’re able to withdraw less than you earn.

How to mitigate your risk

However, it’s key to recognize that the market does not go up in a straight line. Some years it’s up 20 percent, while other years it’s down 15 percent or more. So few financial advisers recommend that you keep all your investments in stocks as you enter retirement or even approach it.

But you can still benefit from having stocks and balance that investment with safer but lower-yielding bonds or CDs and take advantage of the benefits of diversification, including reduced risk.

For example, if you held 50 percent of your portfolio in stocks and 50 percent in bonds, you could earn the market’s 10 percent average annual return for half your portfolio and a bond return of perhaps 3 percent. Average those together, and you could still get a 6.5 percent return each year — still above a conservative withdrawal rate of 4 percent.

If you want to add lower-risk bonds to your portfolio, you can continue to do that and reduce your risk further but it also lowers your overall return. It’s important to note that such a strategy will also probably lower your future payouts, too, because it hurts growth in your investments.

Let’s run some real-life numbers

We’ve some basic numbers here, so now let’s work backward to figure out what you should be saving for retirement. Of course, what you’ll actually need depends so much on your individual circumstances, such as whether you still have a mortgage. Rising healthcare expenses are another factor to consider, but those potential expenses aren’t easy to project.

Based on median earnings for 2019 of $47,684, let’s assume a married couple has twice that and per guidelines, you want to replace 80 percent of your income in retirement. That means you’ll need $76,294 each year. Again, a paid-off mortgage means you may need less.

Each year, you’ll also receive Social Security. The average monthly benefit is $1,503 in 2020, up a modest 1.6 percent from last year. That provides $36,072 in annual income for a couple.

Then you’ll also want to subtract any other pension benefits that you receive. Some workers have pensions, 403(b) or 457(b) plans that can make the burden lighter.

In our hypothetical example, you’re left with a deficit of $40,222 to make up. Using the 4 percent rule and multiplying your goal by 25, you’ll need retirement accounts of just over $1 million ($1,005,550). That’s how much you would need if you intended to retire today.

As prices continue to rise, however, you’ll need more money in the future to retire comfortably. That’s why you need at least some of your portfolio in higher-return vehicles such as stocks.

Growth also gives you the ability to navigate the potential challenges of so many unknown variables in your retirement plan, such as the following:

  • How much will you take from your retirement accounts? The lower the percentage, the longer your money can grow, and so the more you can take in the future.
  • Will your lifestyle change in retirement (go up or down)? If you trim your retirement budget, your money will last longer.
  • How much are you likely to receive in Social Security benefits? The more you receive in benefits, the less you’ll need to save in retirement accounts.
  • If you’re married, will your spouse continue to work when you’re retired? A working spouse means you can retain a higher standard of living longer and let your investments grow more.
  • Are you a man or woman and funding your retirement alone? Women are paid less than men on average and that difference also affects retirement benefits such as Social Security.
  • How much will healthcare cost? Costs have been rising at a fast clip for years.
  • Can you expect an inheritance that might make a difference? It’s not wise to expect any extra money along the way: You may not get any and any money you do receive is not likely to be life-changing.
  • Are you willing or able to move to a lower-cost state? Lower costs, such as taxes, mean your money goes further and you have to save less today.
  • Where will tax rates be in the future? No one has any idea of the answer.

Bottom line

In planning for retirement, you have to factor in your individual circumstances, not only what an average individual retirement might be. This is where Bankrate’s retirement calculator can help you determine what you need to do to reach your retirement goals.

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