Retirement Needs as a Percentage of Income

The easiest and least complicated method for estimating your future retirement needs is to use a percentage of your current income. The general rule of thumb is that your retirement expenses will be 60 to 80 percent of your current after-tax income.

Example Paul is a 40-year-old assembly line worker earning $40,000 a year. After being taxed at a combined (state and federal) tax rate of 40 percent, he is left with $24,000 of income. He calculates that his potential retirement expenses will be $19,200 ($24,000 x 0.8) each year and factors this amount into his retirement planning.

Using a factor of 80 percent or more provides a more conservative approach to estimating your potential retirement expenses. Conversely, the lower the percentage you use in your calculations, the lower the safety cushion you build for yourself. Using any percentage below 60 percent would probably lead to you falling far short of the funds you will need to retire with.

In addition to calculating your basic retirement needs, you can also factor in the costs of any major expenses that you know about in advance. These expenses may include the costs of travel, hobby activities, children's college educations, elder care for parents, or funeral expenses.

Example Paul, the assembly line worker, plans to do some traveling as soon as he retires in 25 years. In today's dollars, the trip he would like to take costs about $10,000. Factoring in the effects of a 4 percent inflation rate, he knows he will need at least $26,700 shortly after retirement. Paul also wants to make sure he has enough money to pay for his funeral expenses. After doing some research, he is shocked to learn that even a no-frills funeral can easily cost $4,000. In addition to the 25 years to retirement, a life expectancy table assures him that he probably has another 18.6 years of life to look forward to after retiring. Using a 4 percent inflation rate once again, he figures out that he will need at least an additional $19,200 at the end of his life to pay for funeral expenses.

As the above example illustrates, additional expenses can easily be factored into the percentage of income method. Unfortunately, this method may oversimplify the calculation of what you will need, causing problems for you down the road.

The major problem with this method is that it doesn't factor in inflation very well. As shown in the example above, the long-term effects of inflation on a given expense can be quite dramatic.

Theoretically, your income should increase every year through raises, promotions or job changes at least as much as the inflation rate. In such case, the percentage of income method doesn't work too badly if you readjust your needs analysis each year. In essence, there is a built-in inflation factor included in your calculation method.

However, if you are a number of years away from retirement and your income stays stable or the cost of living increases sharply, you will have trouble making ends meet both before and after retirement. So if you use the percentage of income method to determine your retirement needs, including a healthy cushion of extra savings is strongly advised.

Another method of figuring how much you need for retirement involves the use of budget calculations.