This is an update to an original post from August 13, 2020
ARE YOU SAVING ENOUGH FOR RETIREMENT?
Financial Advisors get asked this question all the time: Am I (or are we) saving enough?
Maybe you have heard of the concept of a retirement number. The idea is that you figure out your number, and when you have that amount in assets – you can retire. The problem is it's like planning a trip around the world 20, 30, even 40 years from now – there are a lot of unknowns.
So let's break it down into three increasingly useful questions.
Q1. How much of my income should I save for retirement?
A. If you do nothing else, save 15% of your gross income at a minimum. Saving 20% is much better. So how do you calculate how much you are actually saving?
Start with your adjusted gross income or AGI. Get out your tax return - it's line 7 on your 1040.
Multiply that by 15% (.15) to get your minimum or 20% (.2) to get your target.
Compare that to actual savings which is:
1. Money going into retirement plans (include employer match)
2. Money going into investment accounts
3. Principal reduction on your mortgage
4. Do not count any money just going to a savings account. That is your emergency fund and not growing to fund your retirement.
5. Do not count the money you are saving for your kid's college expenses.
6. Do not count any money earmarked for other consumption, such as a car or vacation.
Example:
Goal:
$150,000 AGI * .2 = $30,000
Current Savings:
10% 401(k) savings = $150,000 * .1 = $15,000
3% company match = $150,000 * .03 = $4,500
Monthly PR average = $700 * 12 months = $8,400/year
$15,000 + $4,500 + $8,400 = $27,900 which is $2,100 short of the goal
Recommendation:
Try to add $175/month ($2,100/yr.) to a brokerage account or increase the 401(k) contribution to 11.5%.
Note, if you are starting to save after age 30, you need to be saving more than 15%. If you are stating to save after age 40, you need to be at 20% or more.
Q2. What percentage of your preretirement income should you aim to generate from your nest egg in retirement?
A: 100%.
"Wait… what?" You may be thinking, "I heard that I would only need 80% of my current income." Well, maybe. But I don't like to rely on maybe, do you?
When I say 100%, it's 100% of your net income. Always compare net to net if possible when planning for retirement. If you have expenses that will go away upon retirement, you can subtract them from your target income.
For example, many people pay off their mortgage at retirement. Another example maybe you are paying for kids' college and waiting until they graduate to retire. Those expenses going away will mean you need less in retirement than you do now.
Q3. How big should your nest egg ultimately be in comparison to your income need?
A. More math is required.
Scenario 1: you are planning to retire at 62-70 years old and plan to take Social Security the same year. Your income barely covers your needs, so fluctuation in retirement income would potentially be disasterous.
If you and your spouse currently take home $120,000/year between the two of you – we will call that "C."
And if you claim Social Security now, you will get $40,000/year – we will call that "SSI."
And you have no pension – we will call that "O."
And you are going to pay off your mortgage where the P&I portion of your payment was $20,000/year (you still have to pay taxes and insurance) – we will call that "EGA."
Medicare and other premiums will be $12,000/year – we will call that "HC."
I'll break it down into two steps. First, calculate the income needed. Second, calculate how much principal is needed to generate that income.
1. Net Investment Income Need (NIN) = Current Net Income (C) - Social Security net Income (SSI) - Other guaranteed net income (O) - Expenses going away (EGA) + increased health insurance cost (HC)
NIN = C - SSI - O - EGA + HC
= $120,000 - $40,000 - $20,000 - $0 + $12,000 = $72,000
My Number (MN) or Nest egg needed = Net Investment Income Need(NIN) / (Safe Withdrawal Rate (SWR) * (1-total tax rate))
Note: the total tax rate is NOT your marginal tax rate; it is the aggregate rate you expect to pay on your income coming from IRAs, Roth accounts, and taxable accounts. For this example, I'll assume you have some Roth assets, and your total tax rate is 15%.
Issue – reasonable people can disagree about the safe withdrawal rate. 4% was the old consensus, but many now argue it's less than that. Remember, the 4% rule was invented to predict how much you can withdraw every year without any variation. The truth is that many families can afford to have some variation in their spending from year to year. Ironicly, the more you have saved at the beginning of retirement, the higher the % you can safely withdraw because there is capacity to withstand variability and still pay for your basic needs.
MN @3% SWR = $72,000/3%*(1-.15) = $2.824 Million --> or 40 times the income need
MN @3.5% SWR = $72,000/3.5%*(1-.15) = $2.42 Million --> or 33.6 times the income need
MN @4% SWR = $72,000/4%*(1-.15) = $2.12 Million --> or 29.4 times the income need
The bottom line: this example couple needs at least $2.12 million to retire, but $2.42 million would be much better. If they are cautious investors who are unwilling to leave nearly half of their nest egg in the stock market, then they need to save $2.824 million before retiring.
Scenario 2: All the inputs are the same, except the couples current income is $220,000 and I'll assume a 20% tax rate. Their income covers needs, wants, and reasonable wishes, so they can withstand fluctuation in retirement income.
NIN = C - SSI - O - EGA + HC
= $220,000 - $40,000 - $20,000 - $0 + $12,000 = $172,000
MN @4% SWR = $172,000/4%*(1-.2) = $3.44 Million --> or 20 times the income need
MN @4.5% SWR = $172,000/4.5%*(1-.2) = $3.06 Million --> or 17.8 times the income need
MN @5% SWR = $172,000/5%*(1-.2) = $2.75 Million --> or 16 times the income need
MN @5.5% SWR = $172,000/5.5%*(1-.2) = $2.5 Million --> or 14.5 times the income need
The bottom line: this example couple needs at least $2.5 million to retire, but $3 million or more would be much better. If they are cautious investors who are unwilling to leave nearly half of their nest egg in the stock market, then they need to save $3.44 million before retiring.
Scenario 3: you plan to retire between 62 and 69 years old, but you will not take Social Security until age 70. (Waiting until 70 is my recommendation for anyone who is in average or better health.)
Go through the same calculations as above to determine MN, but use the amount you would get from social security if you retired in your retirement year.
You will need to withdraw your full NIN (which will be more than 4% of your savings) each year before age 70, but your Social Security benefit will increase 8% for every year you wait to begin collecting benefits.
When you reach age 70, begin collecting SS benefits and either take a lower withdrawal rate or enjoy more income from your savings, depending on your caution as an investor.
If you want to retire before age 62, a more complicated analysis is needed. Please contact me to find out if that is possible.
Determining your safe withdrawal rate usually requires the assistance of an unbiased professional. Talk to your Fee-only planner to make that calculation.
I hope you found this information useful. Please share and join the conversation using the social media icons below to the right.
All the Best!
Gordon Achtermann