Calculating the Dollars for Retirement

My last post on why maxing out your 401(k) could be bad for early retirement left out one important thing – figuring out how much you need in your mid- and long-term accounts before you can safely retire. Like I mentioned in that post, my mid-term money is in a brokerage account and my long-term money is in a 401(k).

Basically, my mid-term account needs to get me from my 40’s to my 60’s and my 401(k) needs to get me from my 60’s until I get put in a pine box – yes, no fancy expensive casket for me, I already have that in my will!

How do you figure out how much you need in these accounts? Truthfully, there’s not a good way and tons of variables – taxes, inflation, investment return fluctuations, recessions, maybe even unexpected expenses. While it’s not simple, here’s the steps I use to get a basic idea.

Step 1: Find Out How Much You Spend

You need to figure out how much you spend per year. I track all my income and expenses with a YMOYL-type spreadsheet. This is one of the best things I have ever done because I am able to go back and check how much I am spending every year. So let’s get in the Mr. Everyday Dollar time-machine, head back to 2008, and take a peek:

  • 2008 – $48,501
  • 2009 – $47,516
  • 2010 – $47,705
  • 2011 – $42,580 – I read the book YMOYL this year and got serious about ER / FI!
  • 2012 – $38,500 – projected, I am currently at $33,458 with 2 months to go!

Wow, 2008 was a scary expensive year when we stepped out of that time-machine. Somehow, I was spending $10,000 more per year then as I do now! It hurts to type that but, keep in mind, what we’re doing here is making a lifestyle change that ratchets back spending and consumerism.

That takes time, years even. And to be successful with something as big as this, it can’t be a crash diet. I can tell you it won’t happen overnight but it will happen by making changes for the better and striving for progress, not perfection.

I’m not even entirely sure how I did it. I do know that fear motivated me. Fear that I would have to work all my life in a job I wasn’t passionate about. Fear that I would work until I was dead. Fear that I wouldn’t be able to follow my dreams on my own terms.

You might wonder what I was spending $10,000 on. Well, it’s what I’m not spending money on as part of my lifestyle change: brown bag lunches, doing my own car maintenance, a $100/week grocery and fun budget, no smartphone, making coffee at home, not buying shit I don’t need, line drying clothes, taking the bus, shopping around my auto/home insurance, pizza and wine nights, planning errands together, ditching cable. And I’ve even added expenses by refinancing my mortgage from a 30 year down to a 15 year.

I’m proud of myself for this and if you’ve done similar you should be proud too! It’s sometimes hard to see the day-to-day benefit of what we’re doing but once you see the bigger picture, it’s really amazing!

Next year I’m hoping to pare my expenses down even further – for one, there won’t be an expensive vacation like I took this year to Argentina – so I am figuring on yearly expenses of $35,000.

Step 2: The Quick and Dirty Calculation

Let’s say you need $35,000 per year for living expenses. How much mid-term money do you need to have?

Take the amount of money you need per year, divided by one minus your tax rate as a percent:

  • $35,000/0.85* = $41,176 is the amount you need before taxes

* Starting in 2013, if your ordinary income tax rate is 15% we’re back up to a 15% tax rate on qualified dividends and a 10-8% rate on long term holdings. We’ll use a 15% rate for this calculation.

Then, assuming a Safe Withdrawal Rate (SWR) of 4%, which almost every financial expert argues about but also seem to agree upon, we take the amount you need before taxes divided by the SWR:

  • $41,176/0.04 = $1,042,650

There you have it. If you need $35,000 a year you need to have about a million everyday dollars in your Walk Away Money Pile (WAMP). That calculation has a 95% probability of lasting for 30 years which should get you to your long-term money in a 401(k) or similar.

Step 3: Use Online Retirement Calculators

Now, let’s play with some retirement calculators! I don’t know why this is, but I can sit and literally spend hours playing with these things. I found a comprehensive list of retirement calculators at Bogleheads and found 2 that I liked a lot: FIRECalc and Fidelity’s Retirement Income Planner (RIP). Since FIRECalc doesn’t require a login, let’s use that one for an example.

Here’s the inputs I used:

  • Spending: $41,176
  • Portfolio: $1,042,650
  • Years: 23 (assume you are 42 and want your portfolio to last until you are 65, 23 years)

Here’s what FIRECalc spits out:

There’s really good news here! What FIRECalc did was to adjust the spending for inflation so the spending power is preserved. And then it looked at the 118 possible 23 year periods in the available data, starting with a portfolio of $1,042,650 and spending the $41,176 amount each year thereafter.

Out of the 118 cycles, the lowest and highest portfolio balance was $55,308 to $4,321,490, with an average of $1,765,280.

The most important news is that there were no failures, meaning the portfolio was not depleted before the end of the 23 years, a success rate of 100.0%.

There’s another tab at the top of the FIRECalc page titled “Not Retired?” that helps to plan for a future retirement. You can add 2 more inputs here: how much you save per year and what year you plan to retire.

I used all my data in this calculation and with a retirement age of 42 FIRECalc calculated that out of 109 possible cycles, 14 failed (portfolio was depleted before the end of the 43 years), for a success rate of 87.2%. If I bump my retirement age to 43, FIRECalc found that 5 cycles failed, for a success rate of 95.4%. And if I bump my retirement age to 44, no failures.

How about an example for someone that is age 22 and wants to retire at 40:

  • Spending: $23,529 (will give you $20,000 a year)
  • Portfolio: $10,000 (a rich uncle gave you money for graduation, you lucky dog)
  • Years: 2055 (retire at 40, have the money last until you’re 65 which will be year 2055)
  • What year you will retire?: 2030
  • How much will you add to your portfolio until then, per year?: $12,000

FIRECalc looked at the 98 possible 43 year periods in the available data and found that 37 cycles failed (portfolio was depleted before the end of the 43 years), a success rate of 62.2%. So, spend less and save more!

I find that retirement calculators will all spit out different results for different reasons. For instance, FIRECalc uses actual market returns whereas RIP uses a Monte Carlo simulation model. I don’t think we’ll ever find the one and only retirement calculator. Doing forecasting like this is probably best done by using a few different calculators and until they consistently produce results within your set target, I wouldn’t consider stepping into early retirement.

What are your favorite retirement calculators or simulators? What’s been your experience planning for early retirement or retirement? What tips can you share?