Four Questions to Decide How Much You Should Be Saving
First, begin by asking yourself four key questions:
How much passive income do you want every year from your investments? This figure should take into account not only the cost of the things you want, such as the price of a new house, but maintenance and upkeep as well. How much volatility are you willing to take? In other words, what is your tolerance for watching your account value gyrate up and down? The more quickly you want to get wealthy, the bigger the swings in value both up and down. You may have to watch your account drop by 50% or go up by 100% when you use aggressive strategies that have the potential to get you to your goal sooner. At what age will you need to access the money? This is important because the huge advantages of tax-free and tax-deferred accounts, such as a Roth IRA and 401(k), won’t be available to you if you want to withdraw the money before you are 59 1/2 years old, something you usually can’t do without a penalty. To what degree are you willing to sacrifice your current standard of living to reach your wealth goals?
Now, let’s look at how these factors work together to answer the question: How much should I invest?
Calculate Annual Income From Your Investments
How much money would it take for you to live the way you want? Would it take $50,000 per year? $150,000? Perhaps $500,000? If you plan to continue working, calculate any income you have from your job, along with any other income you may have. Subtract that from your total goal, then divide the figure by 0.04 to find out the assets it would take to support that level of annual income. Why 0.04, you ask? Many financial planners calculate that an investor could withdraw 4% of their money each year and the account would still generate enough, over time, to maintain its current value after adjusting for inflation. This is an oversimplified rule, but we’ll use it for our basic illustration.
Determine Your Monthly Savings Target
Now, you need to figure out how soon you want the money. Using any one of the thousands of savings online calculators (check out one from the U.S. Securities and Exchange Commission, for instance), you can plug in your numbers and figure out what it would take in terms of monthly savings to reach your goal.
$80,000 – $35,000 = $45,000$45,000 / .04 = $1,125,000
You’d need $1.125 million in a diversified portfolio to cover the extra $45,000 per year that you need and have a high probably of it lasting for 30 years. Assuming you can earn 8% on your investments and you want to retire at 65, here’s how much you’d need to set aside each month based on when you start:
Starting at age 45: $1,909.04 per monthStarting at age 35: $754.84 per monthStarting at age 25: $322.25 per monthStarting at age 18: $181.08 per month
If you don’t want to leave anything to your family, friends, or charity, the savings figures would be much lower because this model assumes you maintain the $1.125 million fund in perpetuity. That is why you’ll see many financial planners estimate your lifespan. They’ll actually design a program so that your money runs out at, say, 85 or 90 years old. If you’d like to leave some money behind, a charitable remainder trust can be a great choice for your leftover savings.
Save More to Reach Your Goal Faster
Because of the power of compounding interest, you can reach your goal much faster by saving more each month. Whether or not you can accomplish that will depend on how much you are willing to sacrifice. Even an extra few hundred dollars per month can mean arriving at your savings goal years, or perhaps even decades, earlier than you otherwise could. Is that worth driving a used car or not ordering anything but water at restaurants? That depends on your priorities, and no one can answer that question for you. It’s important to understand, however, that sacrifices in your present lifestyle will make saving much easier. Living within your means and avoiding debt is the most critical aspect of building a sizable investment portfolio. You can use the same calculator from earlier in the article to increase the savings amount you are willing to put in each month. It will generate a new answer, showing you how soon you will reach your goal. In the case of our earlier example, the 25-year-old that was willing to kick in the extra $260 per month would be able to retire at 58 years old, or seven years earlier than planned. Is that worth it to you? Again, only you can answer that question.
Know When You’re Saving Too Much
It’s possible to take this too far. As a famed economist, John Maynard Keynes, pointed out, “In the long-run, we are all dead.” Money is simply a means for you to have the kind of lifestyle you want and open doors of opportunity for your family. When you sacrifice all opportunities for enjoying life, having a new experience, or giving to others, you may ultimately lose out.
