"The question isn't at what age I want to retire, it's at what income." - George Foreman
Let's talk about finding our "magic number" in retirement. This is the amount of money you need to save to give you the retirement income you want. The challenge in this equation while it may sound simple is that it's ever changing. Every year you don't save, you have to save a larger share of income each year ahead. Every year you don't save, you push back your potential retirement date which also increases social security, the impact of inflation, and weakens the benefit of compounding investment growth. Apply a rule of thumb or two and you at least have a target, but this magic number can be elusive.
The most common rule applied in search of the magic number is the 4% rule of thumb as discussed last week. This can be very scary seeing huge annual saving rates simply to sustain an adequate income. You can't use this rule alone! There's always more. For the 4% rule to be remotely accurate, you must understand your replacement ratio. This is very important in calculating your magic number. Without knowing this information, assumptions could be very inaccurate. The Replacement ratio is the amount of income we need in retirement to sustain an equal or similar standard of living as we had during working years. Here's why it's important: Before retiring, we have substantial costs that just don't exist or are greatly diminished after our working years are over. Let's take a few for example:
- Taxes - lower earned income, special deductions and no employment taxes greatly reduce this burden - especially with planning.
- Savings - if we've retired, we stop saving for retirement.
- Transportation - without the 5 day commute to and from work, most retirees drive considerably less.
Why does that matter? Imagine you make $100,000 per year, and that's the income we want in retirement. Also assume you're retiring tomorrow and don't have social security (for simplicity.) By applying the 4% rule alone to our $100k income, an investment pool $2,500,000 would supply the needed income plain and simple. Goal set. Start saving...
Knowing there's more to your story is so important. With the $100k income, you save 10% for retirement, being self employed, you pay 15% employment taxes and you travel a lot costing about 10% of your income per year. Considering these facts, $100k isn't what you spend, it's what you make. The reality is that you spend about $65k of your income and $35k wouldn't be there if you didn't work. So to have the same standard of living after saving, employment taxes, and travel are gone... You only need 65% of your prior income. That's your replacement ratio. Using the 4% "rule" alone, you only need to save $1,625,000.
There always seems to be more to every story. This simple illustration is to show that there are many more factors to consider beyond taxes and savings. Be cognizant of the increased costs of health care, entertainment, travel, utilities and more in retirement. Also understand the many factors may even reduce savings needs - such as social security, inheritance, income earning property and more. Finding your magic number isn't as simple as using a rule of thumb. It's an ongoing exercise that can change dramatically as you get closer to retirement. I'd enjoy helping you find it.