What’s Your Retirement Number?

As anyone who uses a fitness app can attest, setting goals can be a valuable motivational tool. The allure of the couch is easier to resist if your Fitbit or Apple Watch informs you that you’re well short of your daily step or exercise target.

Likewise, visualizing a retirement goal—and working toward a specific number—can motivate you to save, even when retirement is years away. “We’ve found that most people find it helpful, regardless of their age, to have an idea of how much they likely should be saving in order to retire at a reasonable age,” says Tom McCarthy, a certified financial planner in Marysville, Ohio. “Without a target, they just don’t know how much to save, how much risk to take and which types of investment accounts to use.”

There are plenty of calculators on the internet that will help you estimate your retirement number. But as with any calculator, your results will depend on the information you provide, which may not always be accurate. And even if your data is on target, your retirement number isn’t static. The amount you’ll need to retire comfortably will change throughout your working career depending on numerous factors, ranging from how much you earn, how long you expect to work and your investment returns.

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Saving for retirement consists of many moving parts, “and no one’s crystal ball is clear enough to set a number and then stop planning,” McCarthy says. Your target number should be reviewed periodically—ideally once a year—to determine whether you’re on track or need to make adjustments to reflect changes in your life (or lifestyle). This exercise becomes particularly important when you’re in your fifties and sixties, when you’ll be able to come up with a better idea of how much money you’ll need to maintain your standard of living.

Starting out

If you’re in your twenties, you should think of saving for retirement as a marathon rather than a sprint. Instead of focusing on the amount of money you’ll need to retire in 40 or 50 years—which may seem completely out of reach—reverse engineer the process. Calculators such as the one at www.dinkytown.net/java/401k-calculator.html will help you see how even modest increases in the amount you save in a 401(k) or other retirement-savings plan will compound over time.

For example, suppose you’re 25, earn $50,000 a year, contribute 5% of your pay to your 401(k) and plan to retire at age 67. If you receive matching contributions of 50% on 6% of pay, you’ll have more than $1 million when you retire (this assumes a 3% annual salary increase and a 6% average annual return on your investments). Bump your contributions up to 6% and you’ll have $1.25 million.

At this age, time is your biggest ally, because even a small amount in contributions will grow and compound free of taxes until you take withdrawals in retirement. If you start saving in your twenties, as much as 60% to 70% of the amount you’ll have saved at retirement will come from investment gains rather than contributions, says Ted Benna, a benefits consultant who is credited with creating the 401(k) plan (see our interview with Benna). “If you wait until age 40 to start saving, it gets flipped the other way—more will come from your contributions than your investment gains,” he says.

You’ll need to save even more if you get a late start and, say, a bear market depresses your investment returns as you approach retirement. Savers who start early, on the other hand, have plenty of time to recover from—or prepare for—market downturns. Starting early also gives you the ability to be aggressive, which means investing most of your savings in stocks—typically via mutual funds or exchange-traded funds—which have historically delivered the highest rate of return.

There’s a good chance you’ll change jobs several times, particularly when you’re starting out. Resist the temp­tation to cash out your retirement-savings plan after you leave your job. A survey by the Transamerica Center for Retirement Studies found that 13% of millennials have at some point in their working years cashed out their 401(k) plans when changing jobs, compared with 6% of Gen Zers and 4% of boomers. Although the amount you’ve saved during your first few years on the job may not seem like much, the hit to your nest egg will be significant. First, the amount you take out will get a lot smaller after you pay taxes and a 10% early-withdrawal penalty on it (you have to be at least 55 and leave your job to avoid that penalty). But you’ll also sacrifice the investment gains you’ve earned. It’s the equivalent of starting a marathon, running six miles, and then returning to mile one. A better option: Roll your savings into your new employer’s 401(k) plan or, if that’s not an option, into an IRA.

Borrowing from your 401(k) may be appealing if you want to pay off high-interest debt. A 401(k) loan won’t trigger taxes and penalties unless you leave your job and don’t repay the remaining balance, but it can still slow your progress. That’s because loans come with an opportunity cost. The amount you’ve borrowed won’t be invested, which means you’ll have to save more to compensate for the lost investment gains. You’ll also pay taxes on the money you use to repay the loan as well as on withdrawals in retirement.

Passing the halfway point

At this juncture, you should have a better sense of when you’d like to retire and how much money you’ll need to achieve that goal. If your progress is lagging, you still have time to accelerate your pace with catch-up contributions. In 2022, workers who are 50 or older can save up to $27,000 ($20,500 plus catch-up contributions of $6,500) in a 401(k) or other employer-provided retirement-savings plan. If you meet income-limit requirements, you can also stash $6,000 in a Roth IRA, plus an additional $1,000 if you are 50 or older (see below). That’s a smart move because withdrawals of earnings from your Roth will be tax-free as long as you’re 59½ or older and have owned a Roth for at least five years. If you don’t meet the income requirements for contributing to a Roth, you can stash the same amount in a traditional IRA.

The past two years of market gains have given many savers a strong tailwind. If investment gains have pumped up your savings, you may be tempted to slack off on contributions, but that’s a temptation you should resist. Financial planners interviewed for this story suggested using an annual rate of 6% when calculating average returns for your portfolio. It’s safer to err on the conservative side than to overestimate your returns, says Devin Pope, a CFP with Albion Financial Group, in Salt Lake City. “If you estimate 10% and get 5%, you’re a long way away” from your goal, he says.

Approaching the finish line

To borrow another sports metaphor, your last decade or so or of working is the retirement red zone, says Jonathan Duggan, a CFP in Frederick, Md. In football, the red zone is the last 20 yards before the goal line. And just as activities in the red zone can determine the outcome of a football game, the decisions you make now will go a long way toward helping you reach your goal.

If you haven’t been keeping track of your living expenses, this is a good time to start, says Adam Wojtkowski, a CFP in Walpole, Mass. “The five- to 10-year window is when you actually have a rough idea of what your spending might be once you decide to make the flip to retirement,” he says. Getting a handle on your spending will help you estimate how much of your income you need to replace in retirement. Most calculators recommend replacing 70% to 80% of your gross income, but that will depend on a number of factors, such as whether you’ll pay off your mortgage before retirement, whether you’ll downsize or move to another location, and even how you plan to spend your time. At this point, you should also be able to estimate how much you’ll receive from Social Security and a pension, if you have one.

If you’re not as far along as you want to be, there’s still time to move the goalposts, whether it means working longer, saving more or downsizing. Alternatively, if you’ve saved consistently and invested wisely, you may be pleasantly surprised to find that you can retire earlier than planned. But before you call it quits, consider these potential budget busters:

Taxes. No matter how much you’ve saved, you’ll have to share some of that money with Uncle Sam. “One of the common mistakes I see when people calculate their retirement number is that they forget about the taxes,” Duggan says. The amount of your tax bill will depend on overall tax rates at the time you retire, your personal tax rate, where you live (because state taxes can also take a bite out of your budget) and, significantly, where you’ve invested your savings. Depending on your situation, “withdrawals will be anything from tax-free to taxed as ordinary income,” Duggan says.

If nearly all of your money is invested in 401(k) plans and other tax-deferred accounts, most of your withdrawals will be taxed at your income tax rate, and you’ll be required to start taking withdrawals at age 72 (see 12 Things You Must Know About RMDs). Withdrawals from Roth IRAs will be tax-free, as long as you’ve owned a Roth for at least five years and are 59½ or older when you take the money out. Capital gains rates on taxable accounts range from 0% to 20%, depending on your income. Many retirees have a combination of these types of accounts in their retirement savings. Consider sitting down with a CFP or tax professional to discuss strategies to manage taxes on your savings.

Health care. If you plan to retire before age 65, you’ll probably need to allocate a big slice of your savings to pay for health insurance. Even after 65, when you’ll be eligible for Medicare, it’s important to budget for your out-of-pocket health care costs, which can be significant. For 2022, the standard premium for Medicare Part B, which covers doctors’ visits and outpatient services, will be $170.10 a month, up nearly 15% from 2021. Retirees who are subject to the high-income surcharge will pay from $238.10 to $578.30 a month, usually based on their 2019 modified adjusted gross income. Fidelity Investments estimates that a 65-year-old couple who retired in 2021 will need to have saved approximately $300,000 (after taxes) to cover health care in retirement. Long-term care can take a big bite out of your savings, too.

How much can you withdraw?

Once you’ve reached your retirement goal, you face another challenge: figuring out how much of your savings you can safely withdraw each year without running out of money.

A guideline that has stood the test of time is the 4% rule, which was developed by William Bengen, an MIT graduate in aeronautics and astronautics who later became a certified financial planner. How it works: In the first year of retirement, withdraw 4% from your IRAs, 401(k)s and other tax-deferred accounts, which is where most workers hold their retirement savings. For every year after that, increase the dollar amount of your annual withdrawal by the previous year’s inflation rate. For example, if you have a $1 million nest egg, you would withdraw $40,000 the first year of retirement. If inflation that year is 2%, in the second year of retirement you would boost your withdrawal to $40,800.

This provides a handy way to calculate whether you’ve saved enough to generate the amount of income you believe you’ll need in retirement. But a recent report by investment research firm Morningstar says retirees may want to consider a more conservative withdrawal rate of 3.3%. Under that scenario, a retiree with $1 million in savings would only be able to withdraw $33,000 in the first year of retirement.

Morningstar’s conclusion is based on a combination of high stock market valuations, which are unlikely to continue, and low yields on fixed-income investments. Its analysis assumes that a retiree has a portfolio consisting of 50% bonds and 50% stocks and will take withdrawals over 30 years.

Reducing the amount you withdraw every year means you’ll need to save more to generate the income you want. But there are steps retirees can take that will allow them to take larger withdrawals without increasing the risk that they’ll outlive their savings. Delaying Social Security is one strategy: You’ll get an 8% credit for each year you delay taking benefits after full retirement age, or FRA, until age 70. (FRA is age 66 if you were born between 1943 and 1954 and gradually rises to 67 for younger people.) Plus, Social Security benefits receive an annual cost-of-living adjustment.

Another strategy is to adjust withdrawals based on market performance, taking smaller amounts during down years and higher withdrawals when the market has performed well. Still another strategy is to forgo inflation adjustments, which would automatically reduce the amount you withdraw.