03/ How much will you need to save up?
By now, you should have taken the annual amount of money you will need in retirement [see 01/] and subtract the annual amount of money from the resources you already have [see 02/].
Example, "I will need $75,000 in retirement. I will have $30,000 a year from Social Security. $75,000 minus $30,000 is $45,000."
Now, take the amount of money you will need each year (in this example: $45,000) and you can multiply it by 25. In our example, 25 times $45,000 equals $1,125,000. Now we know the amount we need to save up to by age 65, which in this example is $1,125,000. Multiply your number by 25 and then write this number down on a piece of paper. You now have a rough idea of the amount of money you will need for 30 years of retirement.
However, this number you have just written down comes with a big disclaimer and may need to be adjusted, see below.
DISCLAIMER: Multiplying 25 is only a way of approximating how much money we will need. If you plan to retire earlier than age 65, you may need to use a number greater than 25. If you think you may have additional care needs in retirement you may need to use a number greater than 25. If you think that you may live longer than 30 years of retirement, because your relatives are extremely long lived or due to medical advances you think will be available in the future, you may need to use a number greater than 25. If you have raised the amount you will need for any reason discussed in this paragraph, write the new number down on a piece of paper. In addition to these considerations, you may need to make the two adjustments described below.
FIRST ADJUSTMENT FOR TAXES: I highly recommend adding additional money to the amount that you will need if you anticipate any taxes on the money you have saved. For instance, will you be on the hook for income taxes (such as with a traditional deferred-tax IRA) or capital gains tax (if, for instance, you have some money in a taxable account). This might require adding 20% or more to the amount you are saving depending upon what the tax rules are during your retirement. On the other hand, if all of your investments are in a Roth IRA, you might not need to make this first adjustment at all because no taxes should be due on your investments when you retire. Roth IRAs will be discussed in step "05/ What type of investment account is right for you?" Once you have made this first adjustment, write your new number down on a piece of paper.
SECOND ADJUSTMENT FOR INFLATION: After you make the first adjustment, I highly recommend adding an additional amount to the money you are saving to compensate for inflation. We adjust for inflation due to the likelihood that the spending power of our money will drop over time. Simpy put, inflation will take a big bite out of our savings depending upon how long our timeline is. If we plan to retire in 5 years, inflation will not take a big bite. But if we plan to retire in 50 years, inflation will take a big bite. Adjusting for inflation means that we may need to save up more than we think we will ned in order to achieve the same results (based on the current buying power of the dollar).
You can use this inflation calculator and see what your money will possibly be worth due to inflation on the first year of your retirement [external site]. Just plug in the amount that you think you will need to save up. Then, enter the number of years between now and the first year of your retirement. Next, enter 3% as the inflation rate. Finally, hit [CALCULATE] and it will give you the amount you will need to save up in order to achieve your goal.
Inflation Adjustment Example: If I am investing over the course of 30 years, I may want to save up more than double what I think I will need. Thus, based on the inflation calculator mentioned above, if I think I will need $1,000,000 for my retirement based on today's value of the dollar, I will actually want to save up $2,427,262 if I want my money to do for me in 30 years what $1,000,000 can do for me today.
Now that you have made your calculations and adjustments, write down the amount of money that you will need in your retirement on a piece of paper. Exactly how you make adjustments on this page is up to you, but it is better to estimate that you will need more money than you will actually need. In other words, it is better to end up with a surplus of money when you retire.