Retirement planning. It seems like a huge task. An undertaking only to be taken on by those who have hours upon hours of time that they can dedicate to the process. Fortunately, those are common misconceptions.
Retirement planning actually only takes about an hour per year. And that hour doesn’t have to be done all at once. You can spend 15 minutes here, and 15 minutes there, and develop your plan. Considering that most of the planning has to do with determining how much you spend now, how much you earn now, how much you would like in retirement, and so forth; you don’t even have to sit down with a financial advisor until it is time to implement that plan. Here’s how you can get started.
Determine Your Income Needs
There is a big myth out there that says during retirement you will need approximately 60% of your pre-retirement income. Nobody is sure where that myth got started, but it proves to be false for the vast majority of people.
Instead, when you sit down to plan for retirement, you should plan on spending exactly the same as you spend now. Your mortgage may go away, and you won’t have to contribute to savings any longer, but most people find ways to spend the same amount. Lifestyles don’t decrease because you are no longer working. If anything, they increase due to more free time to pursue hobbies.
Let’s suppose that you are living on $4,000 per month now. That means during retirement, you will still need $4,000 per month.
Accumulating Wealth to Generate $4,000 Per Month
There are a number of ways to accumulate wealth. Most people do so by working. They set aside a portion of their income in a 401k, and when they retire they draw on that income. Others will invest in things like real estate. The properties that they own will generate income for them.
Regardless, you need to know a few things. First, when do you want to retire? Second, how much do you need to save to get there? These are the biggest determining factors to meet your retirement goals.
But that is for another discussion at another time. For now you need to know that you should be earning more on the side, slashing expenses, and investing your money properly. This is going to bring you to your “magical” retirement number.
Your Magical Retirement Number
As indicated, you need $4,000 per month to survive. We can now reverse engineer the number that you need to be able to comfortably retire.
$4,000 per month is $48,000 per year. Let’s just call it $50,000 to accommodate unexpected expenses. Using the 4% rule we can determine that you need $1,250,000 to retire. Let’s see how that is done.
We can safely assume that your investments will generate 4% per year in perpetuity. That’s a fancy way of saying you can withdraw 4% of the account value from your investments forever. If $50,000 is 4% of the overall account, we simply divide $50,000 by .04 to reach a number of $1.25 million.
Now we can’t exactly stop there though. We have to account for 2 other variables that could make this whole analysis worthless.
Inflation and Market Declines
Inflation and market declines can destroy a portfolio in a matter of weeks. But there are ways to combat these inevitabilities.
To combat the risk of inflation, you simply have to realize that you will need to save more than you thought. So instead of $1.25 million as our analysis previously determined, you will need to save closer to $1.5 million.
That $1.5 million, however, can quickly be cut in half during a severe recession. If you are drawing from your account during that time, you will deplete your nest egg much faster than you anticipated. But there is a way around market risk as well.
You will want to keep an additional 1/5 of your portfolio (our magical number is now up to about $1.8million) in an account that is not subject to market risk. So cash savings, permanent life insurance, government bonds, or the like. During times when the market has dropped severely, you live off of these savings and allow your investment portfolio to recover. When it has recovered, you slowly replenish your savings.
Investing, Saving, and Planning for Retirement
The biggest hurdle for planning for retirement is determining how much you will need to live on. Financial advisors have some fancy software that can help you determine that number, but you can do it yourself pretty easily.
Now that you know how much you need to retire comfortably, the last step is determining when you want to retire. Knowing how many years you have is all that is needed to determine how much you have to set aside each year.
Don’t be surprised when you realize that you can’t save enough; you will likely have to adjust one, or more, of your numbers.
Practical Taxes Can Help
As mentioned, these calculations don’t take into account taxes. That can throw a big wrench in your retirement planning. Fortunately, we can help when it comes time for taxes. We know how to minimize taxes, which accounts would be best for tax advantages, and can even prepare your tax return so you get the biggest refund possible.