How much do you need to retire? The answer to that question depends on a number of factors: the retirement living level of comfort you expect to enjoy during retirement, how early you hope to retire, the level of retirement saving you've done up until now, and your financial savvy.
Your retirement savings will be used to pay for everything in your twilight years -- not just lavish travel and vacation homes but also paying the electricity bill and buying groceries. It is essential that you save enough to cover every expense you'll encounter during retirement living.
If you were comfortable on an annual salary of $70,000 before retirement, you'll more than likely be comfortable on the same during retirement. But that $70,000 before retirement was also used to cover costs that you won't incur as a retiree: gas for the commute to work, depreciation on your car, etc.
You'll have more free time while retired, however, and you should account for that. Also consider that your lifestyle requirements will change during your savings horizon as you advance in your career and become accustomed to a higher income.
A good rule of thumb is to plan to spend about as much money in each year of retirement living as you did in the years before retirement. But does that mean you need to save every penny of your salary before retirement? No.
Your retirement savings -- whether they be through an IRA, a 401(k), or any other investment vehicle -- compound interest yearly. What this means is that, as you invest money into your retirement planning, your total savings earns interest. So the 10% interest you earn on your first retirement savings account investment gets added to the total amount, which in turn earns 10% the next year.
The concept of compounded interest is complicated -- but you don't need to be a math whiz to figure out how much you need to save each year to live comfortably in retirement. Many free "retirement calculators" are available on the internet and can show you exactly how much money you need to save each year to live comfortably during your twilight years. This tool makes retirement planning that much easier and should be utilized.
A retirement calculator uses a few inputs to determine how much you need to retire by saving each year to live comfortably in retirement: your current age, the year you expect to retire, your current income, your current savings, the expected return on your investments, your annual salary increase, the amount of money you expect to spend in each year of retirement, and the expected rate of inflation over your retirement horizon. If you don't know what some of these terms mean or don't want to guess randomly, just use the amounts provided by the retirement calculator.
The retirement calculator will then compute, given the inputs, the total amount of money you'll have at retirement. Remember that this number will change if any of the above inputs change during the saving process or during your retirement.
One example of this can be found in the return on your investment during the savings process. If you forecast a 10% year-over-year return on your investments during the savings process and that number ends up being 5% for two years during a recession, your total retirement savings will be dramatically decreased because of the power of compounded interest.
This example illustrates the need for prudent financial planning in preparation for retirement. Your twilight years are meant to be the capstone of a life of achievement, not a stressful exercise in penny-pinching. Thorough retirement planning is a necessity; your investments now represent your lifestyle allowances during retirement, so it is absolutely crucial that you investigate your options and make knowledgeable decisions.