To begin figuring out just how much you’ll need to live on, estimate the average rate of inflation you expect along with the annual rate of return you expect on your investments. It’s tough to see intothe future, so to be on the safe side, go with conservative figures–say a 3 to 4 percent inflation rate, and 9 percent investment return on money you commit to stock. Look at your tax bracket, the number of years until your retirement and the number of years you expect to be retired. Your accountant can help you crunch the numbers, or you may want to invest in one of the many retirement-planning software packages currently on the market.
While some would disagree, most investment advisers say you will need 80 percent of your current pretax income adjusted for inflation to maintain your current standard of living. For a more precise estimate, look at your current spending and figure out how much you’ll need to get by once your working days are over. Expenses like mortgage payments could drop considerably in retirement if you trade down to a smaller house, while doctor bills and vacation expenses could escalate considerably.
You’ll need to calculate your social-security benefit and figure how much of it, if any, will be taxable (call the Social Security Administration at 800-772-1213 to get an estimate of your future benefit), as well as the net amount of your pension income after tax. Write down any other sources of income, including earnings, interest and dividends and annuities. By subtracting your retirement expenses from your retirement income, you’ll come up with any shortfall you’ll need to make up when you’re handed that gold watch.
Figure the potential value of all your tax-deferred savings–like 401(K) plans and IRAs–at the time of your retirement. (Keep in mind that the results of compounding can be stunning. For example, a 25-year-old who puts $100 per month into a tax-deferred plan that earns 12 percent a year would have $1.2 million 40 years later. A 40-year-old who socks away $500 a month earning at the same rate will still accumulate almost $1 million by the time he reaches 65.) Then do the same thing for all the investments you bought with after-tax dollars (mutual funds, stocks, bonds, investment real estate and other assets). Add the estimated future value of all your investments together.
Take your mortgage balance and other long-term loans into account, as well as responsibilities like tuition for a grandchild, care of parents, funeral expenses and an emergency stash. (Most financial planners recommend squirreling away at least three months’ expenses.) Also note other sources of capital, such as an inheritance that might come to you or the money from the sale of your home.
The bottom line is the percentage of your annual income that has to be invested annually to meet your retirement goal, assuming that your income keeps pace with inflation. If the amount of income you’ll have comes out to, say, $3,000 a month and your retirement expenses are $3,500 a month, you have a number of options in making up the shortfall. You can: sock more away in your tax-deferred savings plan, adjust your budget so you’re not spending as much or work longer and retire in 20 years instead of 15.
