One common question that I’m asked all the time is how exactly a person can figure out how much they need to save for retirement including their potential Social Security benefits.
In the past on The Simple Dollar, when I’ve done calculations regarding retirement savings, I’ve completely ignored Social Security benefits. I’m in my thirties, which means that I won’t tap Social Security benefits under the current rules for at least 30 more years. That is more than ample time for the rules to change significantly, including changes that could postpone the retirement age and also cut benefits.
In short, I personally do not believe that the current level of Social Security benefits will exist when I reach retirement age. Because of that uncertainty, I don’t include Social Security at all when I do my own retirement calculations. If I do receive benefits, I will view them as an extra bonus.
That personal opinion, however, does not change the fact that, for now, Social Security is a pledged benefit to those who have contributed enough to earn that benefit (usually through working full time for many years). Many, many Americans rely on that benefit today to make ends meet, and many more will come to rely on that benefit as they reach retirement age and exit the workforce.
My parents are currently in that latter boat. Although my father receives a guaranteed pension, they would still have difficulty surviving if it were not for the additional money that comes to them in the form of their Social Security check. They planned ahead using that pension, a small amount in a 401(k), and their Social Security to be able to survive in their retirement years.
Today, very few of us have a pension that we can look forward to relying on when we retire. We have to save for ourselves, and that usually takes the form of a 401(k) or a Roth IRA. The question is how much do we really need to save?
Using Social Security as a tool to help you estimate your needed retirement savings is actually pretty easy, so let’s get started.
Step One: Figure Out What You’ll Actually Need in Retirement
This first step has nothing at all to do with savings or anything else. Instead, it’s an estimate of how much you’ll need to have to survive in retirement.
I always encourage people to calculate this amount in pre-tax dollars based on a person’s salary without the income taxes or other benefits taken out. There are several reasons for this, the biggest one being that most of the retirement benefits that people take advantage of are calculated in pre-tax dollars. So, when you’re calculating retirement savings, don’t worry about pre-tax or post-tax – instead, just view the post-tax accounts as being likely to provide a bit of a tax break for you when you’re actually in retirement.
So, how do you figure out how much you’ll need in retirement? The first thing you should do is look at your current salary (or salaries, if you’re doing this as a combined calculation) and the current amount of your total personal contribution to savings. So, for example, let’s say you earn $50,000 a year and you contribute 10% to your 401(k), but that’s your only significant savings. That would mean that your current salary minus your contributions is $45,000 a year.
Study after study has shown that people spend less in retirement. The often-quoted percentage of your current spending is 80%, so multiply the number you figured out from your current salary minus your savings by 0.8. In the case of the $45,000 number, that leaves you with $36,000.
You’ll need $36,000 in today’s dollars per year to survive in retirement with a lifestyle comparable to a person earning $50,000 today while putting 10% of his/her income into a 401(k).
Now, you’re going to want to inflate that number, because inflation is a real thing. I usually recommend people look at how much inflation there will be between now and 10 years past their retirement date, so that inflation doesn’t sneak up on them.
So, decide on what age you think you will retire and add 10 to that. If you’re going to retire at age 65, for example, add 10 to get 75.
Then, you’ll want to know how many years there are between your current age and that “inflated” retirement age. So, let’s say you’re 40 today. Just take 75 and subtract 40 from that, giving you 35 – that’s how many years of inflation you’re going to worry about.
Then, head over to this nifty calculator. Put in your current “dollars per year to survive in retirement” into the “Today’s Amount” space, leave the annual inflation rate alone (3% is a very good number to use), and put the number of years of inflation you’re thinking about into the “Number of Years” space and hit “Calculate.”
In the example above, with the person needing $36,000 a year in retirement and having 35 years of inflation to consider, that person will need $101,395 per year in retirement income to survive.
That might seem like a lot, but remember that number includes another 35 years of inflation. Things like a gallon of milk will cost on the order of $15 at that point.
Step Two: Figure Out Your Likely Benefits
The first thing you need to do is figure out how much you’re going to earn from Social Security benefits when you retire. The Social Security Administration offers an online tool that makes it easy to estimate your benefits.
However, there’s one key piece of information that you have to decide for yourself. At what age are you planning on retiring? Social Security offers different benefits for different retirement ages, with lower benefits if you start receiving benefits at age 62 and higher benefits if you put off receiving benefits until a later age.
Using the data above, assuming a $50,000 annual current salary and a retirement age 30 years down the road, the calculator estimated that I would receive $1,800 per month in Social Security benefits in retirement.
Note that this amount doesn’t take inflation into account. As it says on the benefits calculator page:
After you start receiving benefits, they will be adjusted for cost-of-living increases.
So, again, you should adjust this number for inflation using the inflation calculator mentioned earlier. The way to do that is to multiply your estimated benefit by twelve – it’s a monthly benefit, so you’re just converting it to an annual benefit – and use the number of years you calculated in step one (in this example, 35 years).
By multiplying $1,800 by 12, I figure out that my annual benefit is $21,600. Then, I use the inflation calculator, plug in $21,600 and 35 years, and discover that my inflation-adjusted benefit is $61,342.
Then, I just take my inflation-adjusted spending estimate – $101,395 – and subtract from that my inflation-adjusted Social Security estimate – $61,342 – and I have the amount I’ll need to come up with on my own per year in retirement – $40,053. We’ll just round that to $40,000 to make it easy.
Step Three: Figuring Out How Much to Save
This is the part of the equation where we start worrying about safe withdrawal rates. The Trinity Study, as discussed in this recent Forbes article, suggested that withdrawing 4% of your balance per year will ensure that your balance survives for at least 30 years in almost any climate provided your investments are reasonably balanced. A 30-year retirement is a pretty good estimate for most people.
However, if you’re worried about those outlier chances – the chances that the stock and bond and real estate markets don’t do well or that you’ll live longer than 30 years in retirement – you may want to consider a lower withdrawal rate. A 3% withdrawal rate would, in almost every environment in American history, provide enough savings to exist nearly forever, far beyond the number of years in a natural lifespan beyond retirement age.
So, let’s look at both sides of that equation.
First, what about the 4% withdrawal rate scenario? You’d need to multiply the amount you need per year from your savings in retirement – $40,000 – by 25, which equals $1 million. That’s the amount you’d need to have in retirement savings when you retire 25 years from now (remember, we’re looking at someone at age 40 who is retiring at age 65, which is 25 years).
What about the 3% withdrawal rate scenario? You’d need to multiply the amount per year by 33, which equals $1.32 million.
Now, that seems like a huge number, but there are a few things working in your favor.
First of all, the earlier you start saving, the greater the power of compound interest. Let’s say that you’ve decided to save 10% of your salary, which in this example is $5,000 a year. That first $5,000 that you save is going to have 25 years to grow before you hit retirement age. If you assume a steady return of 7% per year on your investments, that’s $27,000 right there.
Second, if you’re contributing a percentage of your income, that amount you contribute will grow with your raises in the future. Even if you simply get 3% cost of living raises in the future, that means that your contributions each year will go up.
Third, your target number is already adjusted for inflation, whereas your dollars today are not. The gap looks big, but that’s only because your target number has 35 years of estimated inflation rolled into it. When you look back at 1980s prices, with gas in the $0.70 per gallon range, it looks quaint. That’s how today’s prices will look to you 30 or 35 years from now.
Finally, you may actually have some income in retirement. Many retirees get bored sitting at home and take on jobs in retirement to get out of the house and to earn a little extra money. These calculations are assuming no additional income in retirement.
So, how much should you save per year?
I think that an easy rule of thumb is this: If you’re starting retirement savings before age 35, you can get away with saving 10% of your income per year and be just fine in retirement. You could probably get away with 10% up to as late as age 40, but I’d encourage you to bump it up before then.
If you’re over 35, you may want to consider a higher percentage. I would add 0.75% for every year you’re over 35 and stick to that percentage until you’re retired. So, if you’re 45, you should consider saving 17.5% of your salary for retirement until you actually retire. If you’re 55, you should consider 25% (at least – you’ll probably need even more than that).
A Big, Big Caveat About Relying on Social Security
There is something really important to note on the Social Security benefits calculator page:
Your estimated benefits are based on current law. The law governing benefit amounts may change because, by 2034, the payroll taxes collected will be enough to pay only about 79 cents for each dollar of scheduled benefits.
This is a huge point. That 2034 date is less than two decades down the road. For me, that 2034 date arrives well in advance of when I would start claiming Social Security benefits.
To me, the $0.79 number isn’t that specifically important. After all, it’s a pretty rough estimate based on future income forecasts and economic projections. The point that really shakes me is that they know that under current projections they won’t be able to pay out the benefits that are scheduled for that point.
For those of us that are younger, that’s something to really worry about. It means that Social Security, in its current form, will not be there for us without some sort of significant policy change that increases the amount of money contributed by each person to Social Security.
Making that kind of political change is extremely difficult. Many interest groups are very much opposed to that kind of change, and it will take a lot of political courage to make it happen. Politicians have been passing the buck regarding that situation for many years and there’s no reason to think that things will be resolved until they are literally pushed up against the wall of Social Security benefits going away. At that point, they’ll be struggling with reduced revenue, so it’s hard to tell what will happen.
My personal suspicion is that benefits will be cut for people under a certain age at some point, and I’m pretty sure I’ll find myself under that cutoff age. That’s why I don’t rely on Social Security benefits for my own calculations, and it’s why I encourage people to save at least 10% per year if they start in their twenties and at least 15% a year if they’re starting in their thirties.
Step Four: The Actual Process of Saving Money
At this point, you should have a estimate of how much you should be saving for retirement each year so that you can have a healthy retirement. That number is probably in the form of a percentage of your current salary.
So, what do you do?
The easiest step for most people is to simply sign up for the retirement plan available at work. Depending on your employer, this could either be a 401(k) plan, a 403(b) plan, or a Thrift Savings Plan, among other options. Sign up to contribute the percentage you calculated, and put that money into a Target Retirement fund if available (there’s usually one available).
So, if you’ve calculated that you need to save 12% per year for retirement, then you should either sign up to contribute that much or adjust your current savings to match that amount.
Some employers offer matching funds for employee contributions to retirement accounts. If you are going to receive some matching funds, you can subtract that percentage number from the amount you’re contributing if you wish, though I would probably just stick with your own calculated number for your personal contributions and view any extra thrown in by your employer as a bonus.
What about a Roth? That word actually means a few different things. If you’re talking about a Roth 401(k) plan (or Roth 403(b) or other Roth plan) offered by your employer, choose that instead of the traditional plans. They offer some tax benefits that will help you out down the road.
On the other hand, you may be curious about setting up your own Roth IRA. An IRA is simply an Individual Retirement Account, which means that it’s a retirement plan you set up yourself by simply contacting an investment firm. I have mine through Vanguard.
A Roth IRA is actually a post-tax account, which means that you pay for it out of your take-home pay, but it has the advantage of requiring you to pay no taxes when you withdraw that money in the future – anything you gain in that account is tax free when you take it out in retirement. That’s a pretty sweet benefit.
Signing up for any of these options is really easy, even the Roth IRA. They just require basic identification of yourself, a selection of your preferred investment option (I usually encourage people to just choose a Target Retirement account with a year attached to it that’s close to when they will retire), and then setting up an automatic payment plan of some kind to fund that retirement savings, which just requires information from your bank or, in the case of your workplace, merely requires a signature.
The actual impact that Social Security will have on the retirement of most people under the age of, say, 50 or so is a tricky thing to talk about. We often perceive it as some kind of guarantee, but the Social Security Administration itself tells us that there isn’t enough money there to pay out all of the promised benefits. Thus, I personally don’t rely on Social Security at all when calculating my personal retirement savings goals.
However, others may feel differently. Many people expect that Social Security will be completely funded in the future and that any shortfalls will be fixed. That’s a future I absolutely hope for, because it means a better retirement for almost everyone in America.
I encourage everyone to save as though there won’t be Social Security, but many people have faith in Social Security and believe that it will be there for them. If you rely on Social Security, then, it becomes much easier to hit a retirement goal that will provide a great lifestyle for you in your golden years.
Regardless of whatever route you decide to follow, it will require you to put aside money from your paycheck starting as soon as possible, and the more you put aside the better. That’s true no matter what you expect to happen to Social Security in the future.
My suggestion? Whether you believe in the future of Social Security or not, save as much as you possibly can for retirement. No one ever regretted having too much money when they retired, after all.