One of the biggest questions that soon-to-be retirees face is how much they need to save in order to retire comfortably. Some people aim to replace a portion of the income they earned while working, often around 80 percent. The key is to figure out how much of your working income you need to replace to maintain your current standard of living.
Everyone’s replacement income ratio is different depending on how much of your income you currently spend. For those who save a high percentage of their income and aim to retire early, the 80 percent replacement ratio estimation may be inaccurate. People who have a very high savings rate will need to replace only enough income to cover their retirement expenditures.
Consider a worker, Michelle, who earns $100,000 annually and saves 30 percent of her income. Each year she lives on $48,000 after taxes and saving, instead of the full amount that she brings in. When Michelle retires, she plans to spend the same amount to maintain her lifestyle. Once her savings and investments are able to generate $48,000 per year after taxes, then Michelle knows she can retire.
Michelle will be able to get by on much less money after she leaves her job because she no longer needs to save for retirement. Her effective tax rate will also fall because of her smaller income and the lower tax rate on interest, dividends, and long-term capital gains. However, it’s worth noting that tax rates could change in the future.
Alternatively, Michelle could decide she wants to save even more of her income. Instead of saving 30 percent of each paycheck, she could save 50 percent. By saving more and learning to live on less, she reduces her after-tax replacement income need from $48,000 to $28,000 per year. The higher saving rate will enable Michelle to grow her nest egg faster. And cultivating and maintaining a more frugal lifestyle now will enable her to withdraw less each year when she retires.
If Michelle spends 70 percent of her income, she will need $1.4 million in savings and investments to retire with the same lifestyle. If she manages to live on half of her income, she will need about $800,000 to cover her current level of expenses in retirement. The higher saving rate and smaller cost-of-living will enable Michelle to retire much faster than the average person.
Of course, many of us do not make $100,000 per year, but the same concept still applies. The less you spend now, the less you’ll need during retirement to cover your bills. And the more you save, the quicker you can leave the workforce behind.
Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.