How much should you save for retirement?

I received a question from one of the subscribers this week – “How much  should I save for retirement in order to maintain the same standard of living as I have now?”  I did modify the original question slightly to generalize it to the broader audience. First, I want to thank you for asking the question.

 

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Do you know that most Americans don’t know the answer to this question. What is even more scary is that not many have ever given considerable thought about it.

This is a fully loaded one and I will try my best to answer without trying to boil the ocean. What I have below is a lot assumptions and one approach to arrive at a nest egg. You can change a few variables, analyze, and determine your personal retirement nest egg needed by going through this post.

 

 

Time Value of Money

There are some basic pre-requisites we need to cover before I answer your question. You first need to understand the Time Value of Money. Once you grasp the time value of money, here is a post that you could read that would reinforce your learning – Sally Has A Retirement Question.

 

How much should you save for retirement

Here are my set of assumptions while we go about with the calculation:

  • At retirement, your home is fully paid off. I don’t believe in carrying a mortgage into retirement.
  • At retirement, your kids are done with college and are leading independent fiscally responsible lives.
  • Your retirement (401k) grows at the rate of 8%.
  • All compounding in this analysis is done on a monthly basis.
  • Your age now is 30.
  • You desired retirement age is 60.
  • You have $0 in your 401k now.
  • Your annual salary now is $75,000.
  • Inflation has been ignored as it will vary over time.
  • Also, salary is typically expected to increase by ~3% per year over the 30 year period which means this empowers you to save more. This has been ignored as well to keep things simple.
  • You need 80% of your current salary to maintain the same standard of living you have now.
  • 80% of $75,000 is $60,000.

 

Life Expectancy and Cash Flow at Retirement

Here is another set of assumptions on life expectancy and cash flow during retirement:

  • You expect to live up to 85.
  • You need $60,000 per year for 25 years right after age 60.
  • Market Interest Rate is 4%. If not, you will need to invest your nest egg in bonds and manage the associated risks. How you manage your nest egg at retirement is outside the scope of this post.
  • You are going to withdraw $5000 on a monthly basis ($5000 * 12 = $60,000)
  • To calculate the required nest egg, in Excel, we need to calculate the present value of future $60,000 per year cash flows over the 25 year period – “=PV(0.04/12, 12*25, -5000)”
  • The nest egg need = $947,262.

 

Retirement Monthly Savings

Now that we have determined you need a nest of $947,262, let us look into how much you need to set aside on a monthly basis to reach a nest egg of $947,262?

  • Your retirement account grows at the rate of 8% per year.
  • Compounding is done on a monthly basis.
  • Your initial balance at age 30 (PV) is $0.
  • Your needed balance at age 60 (FV) is $947,262.
  • With this information you can calculate the monthly contribution you need to make towards your 401K by calculating for PMT.
  • In Excel, type “=PMT(0.08/12, 12*30, 0, 947262)”.
  • You need to invest $635.59 per month into your 401k.
  • This translates to $7,627 per year or ~10.17% of your annual salary of  $75,000.

 

Your situation may or may not match the above scenario. However, you know the assumptions, how to draw a timeline, and how to use Excel. I encourage you to analyze your personal situation and draw your own conclusions. And of course, I would love to hear your feedback.

 

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