One of the things that many people worry about regarding retirement is whether or not they'll have enough money saved to live comfortably in those years. Of course, comfort is relative to the person, their current lifestyle, and the lifestyle they wish to live in retirement, but generally speaking, there are some steps you can take and rules of thumb to follow that ensure you can accomplish this.
Here is a magic trick that can help you retire a millionaire.
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Compound interest works wonders
Albert Einstein is often credited with calling compound interest the "8th wonder of the world" -- and with good reason. Simply put, compound interest is when your money earns interest, and in turn, that interest begins to earn interest on itself. If you look at it from a debt perspective, compound interest can be your financial enemy. Take credit card debt, for example. When you rack up credit card debt, you'll owe interest on that money, and as that debt grows, you'll owe interest on the increased amount. It's a cycle you'll want to avoid.
However, when you view compound interest from a saving and investing perspective, you'll really see where the magic is and how this phenomenon can be your key to retiring a millionaire.
Let's use the following scenario as an example: Someone contributes $500 monthly to an investment account that returns 10% annually (approximately the historical return of the S&P 500) for 35 years. Below you'll see the difference in account value when you let the interest compound versus removing it and only keeping the contributions.
| Total Contributions | Withdraw Interest? | Account Value After 35 Years |
|---|---|---|
| $210,000 | Yes | $210,000 |
| $210,000 | No | $1.62 million |
If you withdraw your interest annually (around $600) and only keep your contributions in the account, at the end of those 35 years, you'd have $210,000 in the account.
However, if you leave the money alone and let compound interest work its magic, at the end of those 35 years, you'd have over $1.6 million in the account. Although you contributed the same amount in both scenarios, compound interest accounted for roughly a $1.4 million difference.
Even if you don't invest $500 monthly, and instead want to focus on maxing out your 401(k) contributions ($20,500 is the maximum allowed for 2022), here's how much you'd have saved by the current retirement age of 67 if you started at the following ages:
- 25 years old: $11.01 million
- 35 years old: $4.12 million
- 45 years old: $1.46 million
How much will you need in retirement?
There is no definite answer to how much you will need in retirement, but conventional wisdom tells us that you should plan to have at least 80% of your pre-retirement income to maintain your current lifestyle. So, if you make $80,000 annually, you'll likely need around $64,000; if you make $100,000, you'll likely need around $80,000; if you make $200,000, you'll likely need around $160,000.
The table below shows how the 80% rule of thumb might look at different pre-retirement income levels.
| Pre-Retirement Annual Income | Approximate Annual Amount Needed in Retirement |
|---|---|
| $80,000 | $64,000 |
| $100,000 | $80,000 |
| $200,000 | $160,000 |
Historically, a rule of thumb has been to follow the "4% rule," which states that retirees can plan to withdraw 4% of their retirement savings annually for 30 years (adjusting for inflation each year) without worrying about outliving their savings. There are undoubtedly limitations to this rule, but it's a good starting point for most people.
To calculate your ideal retirement savings based on the 4% rule, multiply 25 by your yearly income required in retirement. So, if your pre-retirement income is $100,000 -- meaning you'll likely need around $80,000 annually in retirement -- you would ideally have $2 million saved up for retirement.
The table below shows approximate retirement savings goals based on the 80% principle and 4% rule.
| Pre-Retirement Annual Income | Approximate Annual Amount Needed in Retirement | Approximate Retirement Savings Goal |
|---|---|---|
| $80,000 | $64,000 | $1.6 million |
| $100,000 | $80,000 | $2 million |
| $200,000 | $160,000 | $4 million |
Use time to your advantage
All things considered, time in the market is more important than timing the market. If your goal is to retire with at least $1 million -- which a lot of people will need to do to maintain their current lifestyle -- then time and compound interest are some of your greatest tools. The best thing you can do is invest regularly, don't touch the account, and let time do its thing. You should always keep your long-term financial goals in mind when making short-term decisions; if you keep that in mind, your future self will surely thank you.
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