As millennials, we hear all the time how we should save our money and invest for retirement, but do any of us actually know how much we should be saving? 2% of our gross salary? 5% of our after-tax income? 10% of the country’s average household GDP adjusted for inflation? What does it all mean?
Well it turns out the amount we actually need to be saving for retirement is a very simple calculation, and it has nothing to do with how much you or I or anybody else earns today.
It depends entirely on how much we think we’ll want to spend in the future.
Generally, a safe rule of thumb is that we will be able to withdraw 4% of our total investments each year in order to keep our principal and adjust for inflation. So, to quickly calculate how much we need to retire, let’s say we can live off $30,000 each year when we’re old, have no kids in the house to pay for, and have no debt (if you don’t think this is realistic – check out mrmoneymustache.com and learn something). By using the 4% withdrawal rule, we will multiply the $30,000 by 25 (1/.04) to get to $750,000 total savings needed to retire.
But how do we determine the amount we should invest each year?
We will need a present value calculator (I use moneychimp.com).
Using me as an example, I am 25 and want to retire in 25 years (at age 50, because I don’t want to be old and half dead when I can finally stop working), so I will need the future value of what I invest today to be $30,000, which is $750,000 divided by 25.
Using a present value calculator, we will enter the future value we want our investment to be (in this case $30,000), our time until we need the money (25 years), and our discount rate (we will use 5% – which is the approximate compound annual growth rate adjusted for inflation for stocks from 1970 to 2015 of 6%, adjusted for a 15% capital gains tax rate).
The present value calculator tells us that this year we should invest $8,800 to end up with $30,000 in 25 years. If we adjust the years to 24, we will find that next year we should invest $9,300 to get the same result. Every year we get closer to retirement, the more we will need to invest to get the same future value result because there will be less compound interest.
I know you’re probably thinking, “There’s no way I can save $8,800 per year right now”. Well I call bullshit. That $8,800 comes out to $170 per week, or $24 per day. I’m positive if we sit down and look over we can find things to cut out of your spending to get us to that goal. And if not? Remember, this is just an estimate based on one set of facts. You can always adjust the number to account for your projected spending during retirement and the age you want to retire. Say we want to work part-time after age 50 and expect to make $10,000? The number we need to save will decrease significantly (it will be less than $6,000 for this year). Same goes if we make the retirement age 65 instead of 50, we’d only need to invest $4,250 this year ($82 per week).
Now how should we invest? We’ll cover that in another episode, but the common recommendation is to diversify our investments as much as possible. Personally, I like to use Betterment for some of my investments because it automatically withdraws money from my bank account (I never miss the money and it takes advantage of dollar cost averaging) and it invests my money in a very diverse range of domestic and foreign stocks and bonds.
I know this was an information dense episode, but remember at the end of the day, a happy retirement is right around the corner. We just need to plan ahead and work towards our goal. And again, the only number that matters is how much we need for retirement. Once we know that number, all it takes is a little math to determine how much we should be investing each year. With a little disciplined investing we’ll be well prepared to retire early and be able to enjoy life. Think how great it will be in 25-30 years to sit back together, drink a beer, and be able to enjoy the next few decades of our lives in comfort.
I hope you enjoyed this episode. Please let us know your thoughts at drunkenmoneypodcast@gmail.com. Check us out on Facebook and Twitter.
