About 25% of Americans do not have a retirement savings plan, which means that this quarter of the population may suffer post-retirement. While this is an alarming figure, anyone can start saving for retirement at any time before the actual event. Regardless of age, you can begin planning for retirement using these basic rules of thumb.
The 80% Rule
This rule assumes that during retirement, you will need at least 80% of the income you had before retirement. The ‘80% rule’ should not be confused with the rule of 80. These rules are best understood by examples.
If you aim to have $500,000 in retirement, you should have an income of $625,000. However, some analysts believe this rule only works for individuals earning $50,000 annually. Individuals earning higher tend to have their income spread out into other investments and assets, which provide enough for them to live on during retirement.
‘100 minus your age’ Rule
This rule takes advantage of the non-related nature of bonds and stocks. Generally, when stocks are at an all-time high, bonds may be at an astounding low. So, the rule works this way: Subtract your age from 100, and the result represents the percentage of your income that should be invested into stocks, while the remaining should be invested into bonds. This rule also augurs well with the advisory that one’s investment in bonds, as a percentage, should be equal to their age.
For example, at age 25, you should invest 75% into stocks and 25% into bonds.
This rule also considers that investing in stocks is a bit riskier than investing in bonds. Therefore, as you get older, your investment options should present fewer instances of risk.
Financial experts argue that while this rule held some ground in the past, its relevance is now somewhat outdated. The rule was formulated when bonds were more profitable; therefore, a higher percentage of income was allocated to them. Investors are looking to bond replacement options that may offer better returns.
Save 15% of your income.
A young adult age 25 should start saving 15% of their income if their preferred retirement age is 62. Most experts advise a saving rate of 10-15% of your income. Using this framework, it is easy to calculate how much of your income you should save if you have begun at, say, age 35 or 45.
Ultimately, this figure should increase consistently. Save from additional sources of income, such as bonuses, raises, or dividends. You could also direct payment amounts for completed loans to retirement plans.
Typically, America’s retirement age is 65. Some people choose to retire earlier, and others later. It is at 65 that Americans can begin to use Medicare. If one saves 15% of their income until 65, their retirement account will probably be enough for their needs.
Start saving now
Save as soon as you can. Saving earlier on in life provides you with the benefit of compound interest. Consider this: you intend to keep $250,000 in retirement, divided into $500 monthly. Starting at age 25 will mean saving for at least 500 months, translating to about 41 years.
Some boosters to increase your savings include contributing more to your 401(k) account and fulfilling set goals. Saving early provides your money with more time to grow.
4% Withdrawal Rule
One of the most straightforward rules of thumb, the 4% withdrawal rule, dictates how much you can spend from your savings account during retirement. It states that you can spend 4% in the first year of retirement. This withdrawal from your account will progressively change, depending on the inflation rate.
For instance, if your savings account has $500,000, you can withdraw $20,000. If the inflation rate is 3% during the second year, you can spend $20,000 ×1.03 = $20,600.
This rule has several caveats. One of them is that your spending levels will not be constant throughout retirement; some monthly allocations may be excessive, while others may be inadequate. Another downside is that it does not consider market changes, such as recessions.
The Rule of 72
This rule helps your project how much time it will take for your money to double at a specified return rate. But why ‘72’? There is no exact answer to this, as 72 is just an approximation of a larger formula. 72 works at a perfect central tendency of an 8% interest rate; working around 8% provides more accurate results. The best range is 6% to 10%.
While calculating using this rule, ensure all percentages are whole numbers and not expressed as decimals. This rule is defined as:
Number of years until your investment doubles = 72 ÷ compound annual interest rate
This formula can be reversed so that:
Compound annual interest rate = 72 ÷ Number of years until your investment doubles.
Please note that this rule does not apply to simple interests.
An example of this rule in action: Assume that your $300,000 investment option offers you an 8% compound annual interest. The expected years until your investment gets to $600,000 can be calculated by dividing 72 by 8 to get 9 years. The result will continue doubling after every other nine years.
Emergency fund equal to six months’ income
Experts advise that your emergency fund should be stocked with at least three to six months of your monthly income. But the big question is: Do retirees really need an emergency fund? The answer is a strong yes. In fact, during retirement, one does not have a steady income, which may warrant the importance of an emergency fund. It is always wise to prepare for rainy days, especially after retirement.
While these rules of thumb have gained traction, not all will work for everyone. Not all these rules account for differences in income, preferences, age, and other factors. It is, therefore, paramount to consider your case individually and consult a professional where you may need help.
Some rules are downright outdated; they do not work in the current market. Do not follow a rule just because it makes logical sense. Some rules may make sense theoretically and work practically for some individuals, but everyone has different financial needs and graphs.