(This post was updated February 13, 2017 to better explain and elaborate on some of the more complex ideas)

Ohhh, the age-old question, “How much do I need to save for retirement?” You are not alone if this seems like an elusive Sherlock Holmes type mystery to you. The good news is you do not need Sherlock Holmes’ deductive abilities or a sidekick named Watson to figure out the answer to this question. You will, however, need to be spending within your means. Your expenses need to be in line with your income, and I would suggest you have a budget in place.

This article is going to show you the amount of money you should be saving annually, as well as the mathematical reasons why you should be saving said amount.

Are you excited? Yeah! Let’s get pumped up! Let’s talk savings!

Savings and spending are directly related

When I say savings and spending are directly related, I’m not making a reference to them being cousins, aunts or uncles, not even children. If savings and spending were two people who lived in Delaware in a nice quaint town on the beach where finishing is their main industry, they would be twins. I’m not even talking fraternal twins, I’m talking identical twins.

Ok, I think you get the picture that they are closely related and have an effect on each other.

You may have read Stock Street’s article on budgeting. If you did not, here is a link to that article if you want to brush up: How to Budget

In the budgeting article, it is suggested you spend no more than 80% of your income after taxes. The 20% or more of your income which you do not spend should go to savings. Spending and savings are directly related.

This chart shows you the relation to spending and savings using a $100,000 annual income, $20,000 paid in taxes, equaling a net income of $80,000.

$100,000 – Annual Income

$20,000 – Tax

$80,000 – After Tax Income

[i]

This is a pretty cool spreadsheet, right? You can see the direct relation to savings and spending. As you can see, the 20% or more recommended after tax savings rate is the equivalent of an 80% or less spending rate. For the $100,000 gross income this would equal an annual savings amount of $16,000 and an annual spending amount of $64,000. It all fits together like a big, fat, puzzle.

I’m a live off 100% of your pre-retirement income kind of guy

If you read a lot of personal finance articles you know a lot of them suggest saving enough to replace 70% – 80% of your pre-retirement income. If you make $100,000 per year, you need to create an income stream of $70,000 – $80,000 per year.

Ok, I get it, you should be able to live off 70% – 80% of your pre-retirement income. But can you live off 70% – 80% and have fun, travel the world, stress less about money, not have to worry about crazy medical expenses? Probably not.

Think of it like this, if you retire at age 65 and the same 2008 financial crisis occurs at age 67, what will happen to you psychologically? You will watch your investment account drop by potentially 40%. If you only saved enough to replace 70% of your pre-retirement income before the drop, your idea of a night out for dinner is going to be free saltine crackers at Wendy’s. I’m sure the misses is going to find that really romantic.  This guy knows what I’m talking about:

If that same 2008 financial crisis happens and you have saved up enough to still feel confident during some market turmoil, your retirement is going to be much more fun.

Therefore, my humble view is to do your best to save 100% of your pre-retirement income.

The 4% rule

Here’s the thing, it’s REALLY difficult to save enough to be able to distribute 100% of your gross pre-retirement earnings in retirement without diminishing your savings before you die. There is a debated rule of finance which states that if a retiree distributes no more than 4% of their retirement account annually, there is a slim chance they will outlive their money.

The 4% rule has come into question lately, so a 3.5% rule may be preferred as a distribution rate in retirement.

This is what a 4% annual distribution rate looks like in retirement:

This is what a 3.5% annual distribution rate looks like in retirement:

If you are still confused about what a distribution rate is, it is the amount of money a retiree distributes from a retirement account annually. If a retiree has $1 million in a retirement account and distributes $40,000 each year, that is a distribution rate of 4% – $40,000 annual income / $100,000,000 retirement account balance = 4%

Combining the 4% rule with psychology and spending

When someone retires, it is my view that retirees do not suddenly change their spending habits. An individual who was frugal their entire life, will likely remain frugal. An individual who is inherently a spendthrift who spends above their means, will likely continue to spend above their means. I don’t believe someone who is retired has a change in psychology.

What may happen, is a retiree may have more time to spend their money doing activities such as going on vacations, playing golf, etc… But, generally, I believe that if an individual replaces what feels like 100% of their pre-retirement income, they will continue to spend the way they did most of their life. The key words here are “what feels like”, which leads to the next idea.

Psychology of budgeting and spending

Three ways

There are only three ways to save enough money for retirement.

1. Luck
   • You were born into a family and inherited money so you didn’t save your own.
   • You got lucky and won the money – via the lottery, or gambling etc…
2. Unfortunate Circumstances
   • An unfortunate circumstance occurred and you received a settlement from a lawsuit.
3. Saved
   • You saved the money via working for it and budgeting and making sacrifices throughout your life.

In most cases, only those from category three will fit into this next group of people; those who have made sacrifices, saved, and budgeted throughout their lives.

Saving FOR retirement is linked the psychologically of spending IN retirement

If you fall into the third category above, it is my belief that you will have a phenomenon occur when you go to retire that will make you feel like you have more money than you do, and will help you get to the psychological feeling of replacing 100% of your income.

In order to explain this, let’s take a look at the math below. If a 30-year-old making an income of $100,000 annually saved 20% of their income after taxes and made a 6.5% rate of return until age 65, this is what the math will look like:

As you can see, this 30-year-old saved 20% of their $100,000 income each year. That savings amount equaled $16,000, and it grows to $1,984,555 by age 65 when that individual wants to retire.

So here is the GIANT, MASSIVE, CRAZY, LOCO, QUESTION: if you saved $16,000 for 35 years and one day you all-of-a-sudden don’t need to save that same $16,000, does that not influence you psychologically? Would you not feel as if you have more money if you made the same amount in retirement, all thing being equal?

Another way to think of it is, for 35 years you are living off 80% of your income after taxes (since 20% is saved for retirement).  When you retire, if you continue to live off 80% of your pre-retirement income, and now you are not saving the 20%, it has an economic and psychological effect of increased income.

Below is what the individual above will feel when they retire after saving $16,000 annually for their entire life.

Remember, the individual has been living on $80,000 of annual income during their working years. But that $80,000 is not what they have been spending, because they have been saving $16,o00 per year. In reality, this person has been spending $64,000 annually ($80,000 – $16,000 = $64,000). So they must feel as if they have MORE money now that they do not need to save for retirement anymore.

This is what the scenario looks like with a 3.5% distribution rate.

As you can see, a 30 year old can save 20% of their income and psychologically get close to replace their entire income in retirement.

This phenomenon has to happen, because savings and spending are directly related. As you saw from the very first chart in this article, you cannot increase your spending by one post-tax dollar without reducing your savings by one post-tax dollar.

Taxes and social security

You may incur a change in taxation in retirement and there will be an effect that social security has on your retirement as well. There are three scenarios to keep in mind:

1. You may pay less taxes in retirement.
2. You may pay more taxes in retirement.
3. You may receive social security.

If you pay less in taxes AND you receive social security, you will have more income than your working years. If you pay more in taxes AND you receive social security, you will likely still have more money in retirement than your working years.

Will you receive social security?

Yes, you will absolutely receive social security when you retire. You heard that all you Negative Nancys out there, Stock Street is stating for a fact that we will all be receiving social security in retirement as long as we have worked the appropriate amount of years in the system. I’m not going to go into a thousand-word explanation as to why I think those who question whether they will receive social security are wrong. Just know that I believe the social security trust fund is completely fixable with some tweaks.

If I am correct (which I am) you will receive social security on top of the projected amount above and you will have plenty of money when you retire at age 65 if you are a 30-year-old and save 20% of your income after taxes.

The 20% savings rate explained

Why a 20% savings rate and not a 15% savings rate? Or a 25% savings rate? Or a 3% savings rate? The reason is because the math works for a long-term savings rate of 20%.

I am going to add a disclaimer here and say the 20% savings rate math works AS LONG AS you are at the correct savings threshold for your age when starting. (More on this below)

This is the table from above which shows what a 20% after tax savings rate looks like for a 30-year-old if they make $100,000 per year and earn an annual rate of return of 6.5%:

This shows that an annual savings rate of 20% of income after taxes will grow to $1,984,555. And we showed what a distribution of that amount of money feels like as you can see here again:

So for a 30 year old starting out saving, it works to save 20% of your income after taxes for retirement.

What if you are starting late?

This chart compares the 30-year-old just starting to save for retirement with a 40-year-old just starting to save for retirement:

[i]

As you see, the 20% savings didn’t work so well for the 40-year-old to retire at age 65. The 40-year-old has over $1 million less than the 30 year old at age 65!

Remember the disclaimer from above? The one that said, “…the 20% savings rate math works AS LONG AS you are at the correct savings threshold for your age when starting.” This 40-year-old is behind schedule; they have $0 of savings and only have 25 years left to get to retirement.

Maybe this person or family is fine living off less than $66,000 per year. Remember, they are used to living on an after-tax amount of $80,000 (minus their savings amount). There are a few options for the person who finds themselves in this situation.

This chart shows the 30 and 40-year-old projections with a few tweaks on the right three columns:

The correct amount of money to have saved

As you can see, the 40-year-old who is making 100k and saving 20% should have about $215,000 already saved in order to replace their gross income at age 65.

If you want to calculate if you are on track for retirement and if the 20% savings rate is ok for you, you can click here and use this Bankrate.com financial calculator to see how you stack up:

Link Bankrate Calculator

If you haven’t saved enough

As you can see from the chart above, if you haven’t saved enough money yet, you still have options. Here are a few options for you:

You can retire later

Here is the chart showing what a 40-year-old can save by age 70. Still less income in than your working years, but still a doable amount of income to live off during your retirement years. If you are just not able to save more than that 20% mark, you can expect to live on less money in retirement, and/or work longer before you are able to retire.

You can increase your savings rate

Here you can see, if you can increase your savings rate to 33% instead of 20%, you will be in good shape by the time you reach age 65.

You can combine these ideas in various ways to figure out how much you will need for retirement. If you are currently behind schedule, you may want to live off less money in retirement, you may want to work longer, you may want to save more, or you may want to combine a few of these concepts.

You can just spend less

You always have the option of spending less in retirement.  For many people it is the option they choose and for many people it works out fine.  But if you are young enough to avoid the need for a lower spending rate in retirement, might as well avoid it!

The Answer

The answer to your profound question “How much should I save for retirement” is a unique answer for each person. You don’t need to be Sherlock Holmes to solve the mystery. The answer depends on your age, your current savings amount, how long you are looking to work, and how much you are willing to spend in retirement.

For those who are not terribly behind on the retirement savings front, a 20% after tax savings rate is going to work well for you. For those who are way behind the savings threshold, you will have to decide what other factors you want to alter to get you to retirement.

The psychological effect of your savings rate throughout your life will help you feel as if you have more money when you retire. This may allow you to sleep better at night knowing that if you are behind on retirement, you may psychologically still feel ok when you retire.

If you are proactive enough to be reading this article to its very end, I have a feeling you will make it to retirement. And that you will enjoy your retirement, you will have great fun in retirement, and you will have a peaceful retirement filled with family, friends, and loved ones. Now go start saving!

[i] I know you may be wondering about inflation. Because we are tying the annual savings amount to annual income, inflation should be built in. Every year the individual makes more money, the amount of money saved increases. It is for that purpose we can consider the future numbers to be in today’s dollars.

[ii] I have estimated social security conservatively to appease those who are weary of social security in the future.