We all dream of that day when we don’t have to go back to work and we can enjoy our free time in retirement… at least, I do. We all know we need to retire, but how do we know if we have enough money saved to have a comfortable retirement?
That is a difficult question to answer because it depends on many different factors, such as your age when you retire, lifestyle, health, and how long you plan on living on retirement money.
There are dozens of retirement calculators that will tell us how much money we will need to retire, but most of them only makes my heart skip a few beats. The numbers those calculators tell us are a little too high, at least for me. My plan is to be able to retire early, but according to those calculators I’ll never be able to retire.
How Much Money Do I Need To Retire?
I don’t know about you, but I don’t want to work until I’m 65 years old. Let me rephrase that, I don’t want to HAVE to work until I’m 65 years old. So maybe the question shouldn’t be “How much money do I need to retire?” but “How much do I need to become financially independent?”
Many people get all worked up when they hear that somebody retired at 40, but still works on their blog or works somewhere else. They argue that you only retire when you don’t work anymore… ever! I see their point, but I also think they need to relax a bit. If you reach a point where you can quit your job and never go back because your money is making enough money to sustain your lifestyle, then you have reached financial independence and therefore you can say you retired, whether you decide to work or not.
So, How much? It depends on who you ask.
Fidelity suggests you should save at least 8 times your ending salary to help increase the chance you won’t outlive your savings during 25 years of retirement. That is, if your end salary is $70,000 you should have at least $560,000 in your retirement account.
To me, this number seems very low especially since they are assuming I’m going to work until I’m 67 years old, will live on only 85% of my salary, and I will be receiving around $2,000 in Social Security benefits. If they are right about Social Security benefits, this number might be good enough if you plan to retire at 67, but I don’t plan on doing that.
This brings me to the second suggestion.
The 4% Rule
The 4% Rule was proposed by William P. Bengen in the article, “Determining Withdrawal Rates Using Historical Data,” published in the Journal of Financial Planning, October 1994. In the article, Bengen argues that a retiree with a diversified portfolio split between stocks and bonds can safely withdraw 4% of their initial balance, adjust the dollar amount for inflation every year, and have an income stream that is sustainable for 30 years.
In order to calculate how much money you’ll need to retire just multiply the amount you spend per year by 25. Just remember you don’t need to use your whole annual salary for this calculation.
Let’s say you make $60,000 a year but are contributing 6% ($3,600) to your 401k, are contributing $5,500 to your Roth IRA, and are putting $700 per month into your savings ($8,400). Assuming that you have a fully funded emergency fund, which you should, then you don’t need to be saving any money. Therefore you only need $42,500 a year to keep your same lifestyle.
So if you multiply $42,500 x 25, you would need $1,062,500 invested and you could retire and not have to worry about your money running out. This of course is assuming an annual return of 7% on your investments — 4% withdrawals + 3% inflation.
There are some naysayers that think the 4% rule no longer applies in today’s market, but I disagree with them. Yes, the market is very volatile and you won’t get 7% return every year, but they are also assuming that you won’t have any other stream of income, such as social security benefits, pension, part time work, or passive income.
The naysayers also assume that we will spend every penny of the 4% and not adjust for economic downturns, but we are smarter than that. We are now “frugal folks” and we realize we don’t need that much money to be happy. When the economy is bad, instead of going to Europe, we’ll go to Latin America or South East Asia where you need less money to live.
Afraid The Money Will Run Out?
Everything in life has risks and relying on 4% of your investments is definitely a risk, but it is a risk I’m willing to take. If you feel less brave, then aim for 3%. However, that means that you will need to work longer in order to save more. If that’s what you want then go for it.
The 4% withdrawal rate is just a reference point. You can adjust it to fit your needs. The one thing I can tell you is that as soon as I reach that 25x mark, I’m out! When will it happen? I can’t really say for sure right now. Since I started late, it looks like I’m going to be playing catch-up for a while, but I’m trying to make some moves to make more money so I can save more and reach my goal faster.
Don’t be afraid of the 4% rule. If you have been doing everything right – have a fully funded emergency fund, paid off your house and have zero debt, and have been able to save 25x your annual expenses, then I would say that you are ready to retire because you know what you’re doing.
So take out a piece of paper and calculate how much money you really need and you’ll see that early retirement is within your reach as well. I always thought that I would have to work until I’m 65 years old – and if I don’t do anything to earn more and save more I might have to – but now I see what I need to do in order to cut my retirement age significantly.
What do you think of the 4% rule? Would you like to work forever or join me for a cocktail in my beach house in Costa Rica?