Don't Wait Until 55 to Think About Retirement
Many people start thinking about retirement only a decade before they want to retire. Even those that diligently invest in their 401 (k) at work don't focus on retirement until it is approaching. Unfortunately, at that age, your options for retiring will consist of living in poverty on Social Security or working for another few decades. If you don't want to start planning your retirement, you better start practicing your "Welcome to Walmart" smile.
How much money will you need?
The first step in planning for retirement is to actually plan your retirement. Not the money part, but the life part. Where will you be living? What will you be doing? How many trips will you want to take? What will you fill your day with?
Begin planning for your retirement by building a basic budget for what you want in retirement. With this budget, you can see how much annual 'income' you will need to retire with that lifestyle. Let's say your desired lifestyle will cost $50,000 a year. Fifty thousand becomes your goal income for retirement. (You can reduce your retirement income by your expected Social Security benefit or pension amount, if you expect to get one.)
The general rule of thumb, based on research by William Bengen, is that if you withdraw 4% of your retirement assets each year, you are unlikely to outlive your money. More recent research, however, has put the safe withdrawal rate at around 3% of your income. So you'll need enough money at retirement so that 3% to 4% of you account is $50,000.
So how much do YOU need?
To figure out how how much money should be in your retirement account when you retire, you can multiply your retirement annual income by the reciprocal of the withdrawal rate. So for the 4% you would multiply by 25 and for 3% multiply by 34. (Did you really think I'd force you to look up what the hell a reciprocal is?)
Our example person with retirement spending of $50,000 per year would need between 1.25 million and 1.75 million dollars. If you're not already scared by this number, remember we also have to adjust it for inflation, so you'll actually need two to three times more depending on how far away retirement is. There is good news, though: the earlier you plan, the easier it is to hit this number.
Assume you earn an inflation-adjusted 7% rate of return and you are shooting for the 1.75 million dollars. If you start in your mid-thirties, you would need to invest about $1,550 per month to hit your retirement goal. If you start at age twenty five, however, your needed investment drops to just $730 per month! Increasing your rate of return to 9% by investing more aggressively will further drop your needed investment to $430 per month.
How much of your income should you save?
How much to save each month is the most important question to answer. In fact, how much to save is significantly more important than answering how to invest the money. The greatest investment strategy in the world won't mean jack if you only have ten thousands dollars in your account. Alternatively, investing with very low rates of return will still succeed if you're starting with millions of dollars.
The best way to answer this question is to seek the advice of a professional financial adviser. To get a handle on it yourself, however, base your savings rate on your age.
Age: 24 and Under
Save 10% of Income
If you are younger than 25 years old, you can secure a comfortable retirement at age 65 by consistently investing 10% of your income into retirement accounts. This assumes that you will increase your retirement savings amount as your income increases to keep the 10% savings rate.
For example, if you were investing $600 per year in retirement and your income doubled after college, you'd need to up your retirement savings to $1,200 per year.
If you want to retire early, however, you'll need to up that percentage. Using the 25-35 year old investing percentage will allow you to retire at age 55. If you want to retire even younger, read the section for those over the age of 35.
Save 15% of Income
Those between the ages of 25 and 35 will have to up their retirement savings to 15% of their income to retire at age 65. Again, you'll need to increase the dollar amount you save as your income increases.
Of course, if you are closer to 25, you won't need to increase your savings rate to the full 15% to see the same benefit as the 35 year old.
You should still consider keeping the 15% savings rate. Saving too much money for retirement has no downside; you'll just be richer in retirement.
Additionally, all of these savings rates assume you have invested appropriately in a stock-heavy, well-diversified portfolio.
Age: 36 and Older
If you are over age 36, you'll need to seek professional help for your retirement. Meaning a financial adviser, not a shrink.
Unfortunately, there is no simple answer to figuring out exactly how much you need to save when you have less than 30 years to retirement. The math becomes very complex and will likely require a professional or a computer program. To figure out your savings rate you'll need to take into account your current savings, your retirement needs, your age, the number of years until you retire, inflation, your average investment rate of return, and other factors.
Taking a Personal Finance class at a local community college can also help.