How do you know how much money you need?

Sun rays

Let’s face it: you probably have no idea how much you need to save in your life.

This isn’t your fault. Like so much of financial security, we’re not taught anything in a comprehensive, start-to-finish sort of way. So we end up hearing snatches of good information (take the employer match, use a Roth IRA, etc.) without understanding where they fit in with a larger picture.

And so, what I’ve found is that people know they have to save money, but don’t know how much, or even how to come up with that figure.

So in this post, I want you to examine your number, if you have one, and figure out where it came from. And if you don’t have a number, maybe it’s time to start thinking of one.

Otherwise, what are you socking away money for?

Don’t outlive your money

My grandfather, after outliving his last partner (he outlived quite a few, the rascal), received a large sum of money from her, in which he lived on.

I don’t know his larger financial situation, but I do know from my parents that he was drawing down his account very fast. And we wondered and worried: what would happen when the money ran out?

He died before we had a chance to find out, which is either a relief or not, depending on how you look at it.

My point is, I do not want you to think of your retirement money being something that you draw down until it’s gone (or you are). So the first rule of long-term savings is:

You must strive to keep a constant balance and live off your earnings.

If you are invested in accounts with a reasonable return for long-term planning, you earn interest on that money. That is the only money you should be using.

A good formula

I believe that a good, safe, long-term average return on investing is around 4%. You don’t have to believe me, but you do find that number more often than not.

So in order to never outlive your money, you need to figure out how much you need to live on, and that’s 4% of the money you need.

(For purposes of discussion, we’re going to ignore the gross/net distinction for now, but note that some accounts you will need to pay tax on, like traditional IRAs, and some you won’t, like Roth IRAs, and this factors into how much you need.)

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So, could you live on $40,000 a year? $40,000 is 4% of $1,000,000, so you would need $1,000,000 saved up in order to not have to worry about outliving your money.

Now, that return is never guaranteed, but some years you’ll earn more and some years you’ll earn less. That’s why we picked 4%, because it’s reasonably safe.

Coming up with that number is hard, I know. Medical bills are a huge part of life in a way that they (hopefully) aren’t in other times of life. So you’ll need to account for that. On the other hand, you may need less money because you’re no longer working. We’ll talk more about that number in future posts.

But the point is that all you really need is that number, a reasonable estimate of returns, and you can figure out how much you need.

How much you don’t need

Now, maybe you’re planning on being Richard Branson or Jeff Bezos or Scrooge McDuck. Maybe you’ve had a large figure in your head. “I need $20 million dollars“.

I admire you for aiming for the stands, but let’s look at your figure. $20 million, at 4%, gives you returns of $800,000 a year. Damn, son, that a hell of a stipend.

But let’s also look at what you’d need to get to $20 million. Assuming 7% returns, that’s putting away $8,000 a month for 30 years. Even if you assume 10% returns, that’s $4,600 a month.

Point being, that’s more money than you’re likely to be able to save, but also, it’s more money than you’re likely to need.

Recap

This is how much money you want to be planning to save:

\text{Total money you need to save} = \frac{\text{Desired yearly income}}{\text{Expected rate of return (4\%)}}
Thank you, LaTeX. Built using Online Equation Editor

Don’t be in the situation of drawing down your balance. I don’t wish that on anyone.

But enough about me. How much money are you looking to save?

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