One of the most important questions you will have to answer before you retire is:
“How big should my 401(k) be to retire?”
And the reason I say “401(k)” is because that is the primary retirement savings vehicle for most people. But if you have some other type of accounts (like a 457 or 403(b) or TSP) that are your retirement savings, then it’s really the same thing.
So if you want to maintain your current lifestyle in retirement and not worry about running out of money, then you need to make sure you have a ballpark idea of how much savings you will need before retiring.
What About Low Interest Rates?
One of the biggest challenges facing people on the verge of retirement is low interest rates. You save money your whole life, and you want that money to generate some earnings for you.
But in the low interest rate environment that we are currently experiencing it can be tough to generate much significant interest income from your nest egg. Gone are the days from the early 80’s when you could put your money in an FDIC insured CD earning 15% interest.
The same is true of bond rates as well. They are very low currently.
Since these safer ways to generate income on savings are not available today, some investors are chasing after higher returns in the equity markets. That’s fine. It’s probably smart for most retirees to have some exposure to the growth potential of the market.
But it doesn’t give guarantees on the income side (through dividends), nor guarantees on principal protection.
Without these guarantees of a certain return and level of income that can be generated from the portfolio, it is hard to know how big your portfolio needs to be to retire.
That puts us back to square one asking, “How much do I need in savings to retire?”
And The Answer To The Question Is…
It turns out the answer to “How big does my 401(k) need to be” will depend on a number of different factors. Here are some of those factors:
- How much is the lifestyle you want to live in retirement going to cost you? The more extravagant your lifestyle, the more money you will need to pay for it. The bigger your 401(k) will need to be before you retire.
- How much retirement income will you have? If you have maximized your Social Security benefit your lifetime income will be greater. What about other income sources, such as a pension? Are there any other sources of income you will have in retirement?
- How soon do you want to retire? The sooner you retire, the longer your money will have to last. The later your retire, the less time your money will have to last.
- Do you want to live off interest and dividends only? Perhaps this gives you comfort to not touch your principal. Perhaps you want to leave your savings to your kids. If this is the case, you will need a bigger 401(k) to generate the earnings necessary for your desired retirement lifestyle.
- Are you willing to spend your principal to cover your retirement expenses? That is why you saved the money, right? If you are willing to spend your principal to cover your needs (and not just rely on interest or dividends from the portfolio) then you will need less in your 401(k) to live the retirement lifestyle you desire.
Some Rules Of Thumb
Rules of thumb are just generalities. But they can be useful to give you a good ballpark estimate when determining how big should my 401(k) be to retire.
First, determine the costs of the retirement lifestyle that you want to live. Does it cost you $5,000 per month? Is it more or less? Get an estimate of this.
Second, determine how much in lifetime income sources you will have. This will typically be Social Security. But it may also include a pension of you are fortunate.
Third, do the lifetime sources of income (Social Security, pension, etc) cover your monthly expenses? If not, then you have an income gap that must be filled.
Your goal should be to fill that gap in the lowest risk, lowest cost way possible. And you must fill this gap for your lifetime, taking into consideration inflation over the rest of your life.
Fourth, here is where the rule of thumb comes in. Take the monthly income gap and multiply it by 12 to show the annual income gap. Now divide that number by 4%. That’s a good ballpark estimation of what your retirement savings should be.
This of course is using the rule of thumb known as the 4% safe withdrawal amount. This rule generally means, take 4% of the value of your portfolio when you retire. Whatever that actual dollar amount is, withdraw that each year (adjusting it upward to account for inflation) and there is a pretty good chance you won’t run out of money. This assumes the portfolio is invested in the market, giving it the potential for market growth along the way.
Let’s see an example using some simple numbers.
If your monthly income gap was $333.33, then just multiply that by 12 and you get $4,000. Then divide $4,000 by 4% and you get $100,000.
FYI, most people’s monthly income gap is going to be way more than $333.33. And thus they will need more than just $100,000 to safely retire. I’m just using that as a simple example to illustrate a point.
Remember, the 4% rule is just a rule of thumb to give you a ballpark estimate. You very well may need more than that in your 401(k) and other retirement savings accounts. You may need more due to market performance being poor. Or you may need more because it gives you more comfort and security in retirement.
If you know someone that is considering retiring, and they are unsure if they have saved enough in their 401(k) and other retirement accounts, then please forward this article to them.
We can reach more people together than I could on my own. You can even click the Facebook share icon on the left of the screen to quickly share this article / video with your friends.
And if you are close to retiring and have questions about what to do with your 401(k), then download my free report “401(k) Rollover 10-Point Checklist For Baby Boomers.” It will take you through the necessary steps on how to rollover your 401(k) and avoid any mistakes.
Best of luck!