How Much to Save for Retirement
"Am I saving enough?"
Various rules of thumb aim to answer this question, but none are specific to your situation and goals. In this post, we review a common rule of thumb for retirement savings and then outline a 6-step process to determine how much you should be saving. After determining how much to save for retirement, see this post to understand which accounts to use to maximize your retirement savings.
Rules of Thumb for Retirement Savings
Undergoing a quick search to figure out "how much to save for retirement" will likely result in a recommendation to save 10%-20% of your gross income. If you are early into your working life with decades until retirement, this is an excellent initial target. However, this rule of thumb begins to break down as soon as any of its assumptions are inapplicable. These assumptions include when you start saving for retirement, when you plan to retire, how much you will spend in retirement, investment returns, other income sources, and more.
Key Assumptions of the 15% guideline include:
- You begin saving for retirement at 25
- You plan to retire at 67
- You will save every year from ages 25 to 67
- Your retirement spending will be about 55% to 80% of your pre-retirement income
- Social Security will cover 10% to 35% of your income needs
- You have no other income sources
To assess whether the 15% guideline is appropriate for your situation, consider if you answer yes to any of the following: Are you getting a later start on saving for retirement? Do you plan to retire early? Retire later? Do you live well below your means? Do you plan to spend more in retirement?
In addition to these variables, as you get into your 30s and 40s, additional savings and spending goals will begin to crop up. Instead of just saving for your retirement, you are also balancing saving for college education(s), your next home, and other goals. At this point, your budget and retirement savings may come under pressure and it's worthwhile to take a more thoughtful approach to determine how much you should be saving for retirement.
Step by Step: Determining How Much to Save for Retirement
1. Estimate Retirement Expenses
American households headed by those 65 and older spent an average of $48,791 per year from 2016-2020. However, this is only an average and your circumstances and goals may vary significantly. For a better estimate of what you should expect to spend in retirement, start with your current budget and make adjustments.
Current Budget +/- Adjustments
To estimate your living expenses in retirement, take your current budget and make adjustments based on expected changes. Don’t get caught up in what you think your specific utilities, groceries, or gas expenses might be 20 years from now. Use today as a good enough estimate, which you will refine as you approach retirement.
Regarding adjustments, consider the big items in your budget today that will very likely change. For example, do you intend to pay off your mortgage before retirement? Are you currently budgeting significant sums for daycare and other child-related expenses? On the flip side, would you like to increase your budget for travel or other goals in retirement? And what are your expectations for medical bills? (Retired Americans average $6,500 per year in medical expenses.)
2. Calculate Pre-tax Income Required
Estimate your federal and state income taxes using an income tax calculator to determine the pre-tax income required to support your lifestyle. Your taxable income will depend upon your types of income, traditional vs. Roth retirement accounts, and other factors.
Once you determine your effective tax rate, divide your retirement expenses by 100% less your effective tax rate to determine the pre-tax income required.
3. Estimate Other Income Sources
Estimate your other income sources in retirement (like social security, pensions, or rental income).
Many of us will retire with social security as our only “fixed” income source in retirement. The rest of our income will have to be generated from our portfolio or other sources.
To estimate your social security income, log-in to your my Social Security account and review your expected income at your retirement age. If you don’t have a my Social Security account, now is a great time to create one.
4. Determine Portfolio Income Required in Retirement
Your retirement savings will have to make up the difference between your pre-tax income required and fixed income sources.
Portfolio Income Required = Pre-tax Income Required less Other Income (Social Security, pension, rental income, etc.)
Subtract your other sources of income from your pre-tax income goal to arrive at how much annual income you will need from your portfolio.
5. Use 4% Rule of Thumb to Estimate Retirement Portfolio Goal
Now that you understand how much income your portfolio will need to provide each year, we can set a target for your retirement portfolio to sustain these annual withdrawals.
The “4% Rule” is a rule of thumb for retirement spending which essentially concludes you should be able to withdraw 4% of your retirement portfolio through your retirement and not risk running out of money. (That’s a vast simplification of the "4% Rule" and there are plenty of arguments as to why 4% is too high or too low, but this simplification is good enough for an estimate.)
To use the 4% rule to estimate your retirement portfolio goal, divide your annual portfolio income need by 4% (or multiply your annual portfolio income need by 25).
If you would like to be more conservative, consider a 3.5% or 3% withdrawal rate. This will increase the amount you will need to save for retirement and is good for a frame of reference.
Again, we are working on a fairly quick and simple calculation for a projected retirement that may be 10, 20, or 30+ years from today. Estimates and quick calculations will suffice.
6. Determine an Annual Savings Target to Reach your Goal
Given your portfolio goal and a few other inputs and assumptions, we can determine how much you should be saving to reach your goal.
Use a financial calculator to estimate how much to save for retirement given your portfolio target, starting amount in your retirement accounts, years until retirement, and expected return.
Example of Determining Retirement Savings Goal
Let’s take a look at an example of a 35-year old couple, John and Emily, earning $160,000 per year with $125,000 saved that would like to retire at 65.
1. Estimate Retirement Expenses
Current Budget +/- Adjustments
John and Emily review their current budget and determine they are spending $9,500 per month.
However, not all of these expenses are expected to continue in retirement. The couple currently spends $1,800 per month on daycare. They also intend to pay off their home before retirement; their principal & interest (P&I) payment is $1,500 per month. This combined $3,300 can be deducted from their current monthly expenses to arrive at $6,200 per month.
John and Emily would like to budget for anticipated annual medical expenses of $6,500 each plus annual travel of $15,000.
Their annual retirement expenses are estimated to be $102,400.
2. Calculate Pre-tax Income Required
John and Emily estimate their combined federal and state effective tax rate will be approximately 15%. Dividing their annual retirement expenses by 100% less their effective tax rate, the couple finds they will need approximately $120,000 in pre-tax income to meet their lifestyle goals.
3. Estimate Other Income Sources
John and Emily expect social security to be their only other income source in retirement. Logging in to their my Social Security accounts, they find their total social security at age 65 is estimated to be $24,000 each, $48,000 in total.
4. Determine Portfolio Income Required in Retirement
Portfolio Income Required = Pre-Tax Income Required less Other Income
Portfolio Income Need = $120,471 - $48,000 = $72,471
5. Use 4% Rule of Thumb to Estimate Retirement Portfolio Goal
Dividing the portfolio income need by 4%, the total portfolio goal is $1,811,765.
For a more conservative estimate, dividing $72,471 by 3%, the total portfolio goal is $2,415,686.
6. Determine an Annual Savings Target to Reach your Goal
Lastly, John and Emily use a financial calculator to determine how much they should save annually.
Assuming a 6% real return on their investment portfolios and targeting $1,811,765 in their retirement portfolios in 30 years, John and Emily would need to save $13,836 per year (~9% of their income) to reach their portfolio goal.
Assuming the more conservative 3% withdrawal rate, or a $2,415,686 target, then John and Emily would need to save $21,475 per year (~13% of their income).
Next Steps: Updating Your Projections and Optimizing Your Savings
Completing these steps will provide an annual retirement savings target for your household. But this is just a point-in-time projection that should be updated periodically (annually will likely suffice). Your retirement plans, investment returns, and more will change over time, but this 6-step process can be revisited to reorient your savings plan.
After calculating how much to target saving each year, you can explore your tax-advantaged savings options (401(k)s, IRAs, HSAs, etc.) to optimize your retirement savings. Explore this post to understand how to structure your retirement savings, which accounts to use, and in which order.