Retirement Planning 101: How Much Money Do You Need?

retirement planningSince I’m now north of 41 years old, retirement planning is tops on my list of things to think about right now.

One of the frequent questions that financial bloggers get is how much money do you need to retire?

Since I’m a lawyer by day and an aspiring financial blogger by early morning hours and night, let me give you a perfectly good lawyer answer…

It depends.

That’s right. It depends on you and your lifestyle and what you want out of retirement.

If you want to live in a beach house on Captiva Island, Florida (a dream for my wife and me), then it’s going to cost a lot more than if you lead a minimalist lifestyle.

So how do we come up with the right number FOR YOU?

Honestly, it all comes down to your budget. If you can live off less and save more, you can retire sooner than if your lifestyle costs more and you save less. It’s simple math.

Let’s look at two examples, a minimalist married couple, and a middle-class family with 3 kids. And in case you were wondering, my family fits squarely in camp number 2.

The Minimalist Family

If you lead what many describe as a minimalist lifestyle, chances are that you do not have many possessions or expenses. You save most of what you earn and pinch pennies when it comes to your expenses. You live in a small house, you have no debt, and you have paid off all of your student loans (if you had any to begin with).

Your total expenses hover around $40,000-$50,000 per year (and that’s probably a reach), but you and your spouse earn well over $120,000 per year. You each max out your 401(k) contributions ($18,000 each in 2016, or $36,000 total), leaving you with roughly $84,000 in pre-tax income. Assuming a 20% tax rate, you have approximately $67,200 left over, of which you save an additional $20,000.

This gives you, our frugal family of the day, roughly $56,000 to set aside for your nest egg each year. In order to retire, your family would need to set aside at least $1.125 million (more on how I came up with that in a minute), assuming that your annual after-tax spending needs are $45,000. This number will certainly go down over time, as you will pay off your mortgage as part of your annual budget.

To get to that amount, you can retire within 13 years, assuming a modest, 7% annual return on your money. The only problem with this scenario, as far as I can see, is that you will have a significant amount (approximately $725,000) in your 401(k)’s when you “retire”, but you won’t be able to take that money out without penalty until you reach age 59 ½.

However, if you are age 30 when you start on this journey, you will be age 43 when you retire. Assuming you only withdraw your annual living expenses from your after-tax portfolio until it is depleted, you won’t deplete this account for at least 14 years. By then, you will be age 57 and could live off your retirement fund in perpetuity.

There are a lot of assumptions at play here. We are assuming a certain rate of return on your money. We are assuming your expenses don’t go up, and we are assuming that you don’t contribute anything else to your retirement portfolio once you “retire”.

Now, let’s take a different example.

Middle-Class Typical American Family

In this second scenario, which I will admit more closely resembles my personal situation, our family has 3 kids, a dog, and more expensive spending habits.

In this situation, the Mom does not work outside the home, and Dad works as a lawyer by day earning approximately $150,000 per year. However, Dad also owns his own law firm and therefore has a great deal more tax deductions at his disposal than our first family. But that is just about the only thing going for this family.

Their expenses hover in the $7,000-8,000 per month range, or $96,000 per year. After taxes, our Dad-of-the-year contributes roughly $25,000 per year to retirement and $10,000 per year to a savings/investment account.

In order to maintain this lifestyle, this family will need to amass roughly $2,400,000 into a retirement fund. They currently have approximately $250,000 in investments, but also have substantial student loan debt (over $100k), and a mortgage with a $250,000 balance.

The $8,000 per month expense number includes the mortgage and student loans. By paying down/off both of these debts, this family would only need $5,000 per month to live off of, meaning that they would only need $1,500,000 in the bank to safely retire.

Assuming they do NOT pay off the student loans or mortgage, it would take them roughly 20 years to accumulate $2.4 million. But if they did start aggressively paying down those debts, it would take roughly 4.5 years to pay all that debt down. But their current nest egg would continue to grow at 7% for those years, leaving them with $340,000 at the end of those 4 and a half years. At that point, they could contribute an additional $36,000 per year to their nest egg, or $71,000 total per year.

At that rate, it would take them 10 additional years to reach their retirement goal of $1.5 million, or 14.5 years total. Our hero could continue to work and saving for 5 more years to get to $2.5 million in the bank, and they would have the same amount that they would have had if they not paid off the debts, and the debts would have been paid off in total. Or they could retire altogether after 14.5 years (if they wanted).

How to Decide How Much You Need to Retire

Right now you are probably asking yourself, “how did you determine how much was needed to retire?” That part is relatively easy. There is a rule of thumb that says that so long as you only pull out 4% of your investment portfolio each year, you will never run out of money. To do this, you must accumulate 25x your annual expenses.

So if your annual expenses are $50,000, you must accumulate $1.25 million. $1.25 million times 4% equals $50,000 per year. If your expenses are $100,000, you must accumulate $2.5 million.

So the higher your budget, the more you must contribute to retirement. And in addition, it will take you longer to reach your retirement number.

What’s the Bottom Line on Retirement Planning for Me?

For me, I think I’ve got my job cut out for me. I need to earn more money as a lawyer, or my family will need to cut our expenses. Also, we need to look carefully at whether it makes sense to pay off those loans and the mortgage, frankly, it looks like it just might (which goes against conventional wisdom, btw). More on this in another post.

Comments? Questions? Is my analysis totally whack? Please feel free to comment below and let me know what you think.