Part 3: Basic Retirement Number Calculations
May 4, 2008 – 6:28 amIn my last post I covered some of the decisions that need to be made before we get down to some calculations. The answers to these questions will be used as inputs as you try to figure out and adjust your retirement calcualtions.
Retirement goals are often referred to as a single number that represents your income-generating net-worth. By this I’m simply referring to the total dollar value of asset you have available to generate income in the future.
What we must keep in mind though is that our real retirement goal is an on-going income, and to get that income we need to make quite a few assumptions.
In order to make this discussion easier to follow, please note that going forward I will use the term “assets” to refer to retirement assets, or funds and valubles that can be invested in order to generate passive income for your retirement income needs.
So how do you figure out how much you need in assets to generate your needed retirement pre-tax income? We’ll cover two approaches.
Easy Way: Assets = Annual Retirement Income / Annual Rate of Return
To solve for “Assets” just divide your required income by your assumed annual rate of return. Here are a couple of data points to consider:
- Stock Market Average Return: 11% (1926-1999) [Source: Ibbotson Associates]
- Government Bonds Average Return: 5.1% (1926-1996) [Source: Ibbotson Associates]
- Treasury Bills Average Return: 3.7% (1926-1996) [Source: Ibbotson Associates]
- Current 1-year CD rate: 3% [Source: Bankrate.com as of 5-1-08]
- Current 5-year CD Rate: 3.4% [Source: Bankrate.com as of 5-1-08]
I think most people who want to go with historical market averages assume 11-12 percent returns before inflation and taxes. I personally use a more conservative 8-10% number usually, but I’ll be covering ways to adjust for uncertainty in your calculations in a later post. For now just pick a rate of return that seems reasonable to you.
Having this number is a great starting point, because it show you the big impact rate of return can have on your retirement goals. Keep in mind it is still a preliminary estimate, because it doesn’t take taxes, inflation, or a few other items into account.
Harder Way: adjust for inflation and taxes
You need to stop using the gross, or pre-tax rate of return and instead use a net rate of return that adjusts for inflation. For example, if you think you’ll earn 10% before tax and inflation will be 3% a year, your after-tax rate of return will be 7%. Just use 7% instead of 10% in the calculation above.
Now let’s adjust for taxes. First we need to determine your assumed tax rate. If you invest for the long term and all of your gains are long term capital gains, your tax rate will be near 15%. If you get a lot of short-term capital gains or income that is taxed at your regular income tax rate, you could pay as much as 35% or more in taxes depending the amount of your income each year. I am not a tax advisor, and it can be a lot of work trying to figure out an exact answer to this question. To keep things simple, let’s assume a 20% tax rate on all gains. At a 20% tax rate your 7% net return is reduced to 5.6% [7%*80%].
In our on-going example, assuming a $50M pre-tax income requirement, an 8% rate of return, 3% inflation, and a 20% tax rate we end up with: $50,000 / [(8%-3%) * (80%)] = $800M, or $800,000. Yikes!
The next post in this series will walk through entering our assumptions into a few of the more straight-forward online calculators.
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