One of the most frequent questions new investors ask is, "How much money should I be saving for my investment portfolio?" Although the question is straightforward, the answer is not so easy because it depends upon a handful of factors that differ with each individual or family. Let’s take a look at the questions and then we can tackle each one specifically.
Before we begin, though, it's important that you understand the difference between saving and investing. To learn more about this and how you should approach both, read Saving vs. Investing - Finding the Right Balance.
The Four Questions To Help You Determine How Much You Should Be Saving
First, begin by asking yourself four questions, then writing down your answers:
- How much passive income do you want every year from your investments? This figure should include not only the acquisition cost of the things you want (e.g., the price of a new house), but maintenance and upkeep, as well (heating, air conditioning, insurance, lawn service, etc.).
- How much volatility (meaning, watching your account value fluctuate) are you willing to take? The more quickly you want to get wealthy, the bigger the swings in value, both on the upside and downside. You may, for instance, have to watch you’re account drop by 50% or go up by 100% for 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 won’t be available to you if you want to withdrawal the money before you are 59 1/2 years old or else you’ll be forced to pay substantial penalties to the IRS (unless you qualify for one of the Eight Ways to Avoid the 10% Early Withdrawal Penalty.
- To what degree are you willing to sacrifice your current standard of living for your wealth goals?
Now, let's look at how these factors work together to answer the question: How much should I be saving?
How Much Money Do You Want From Your Investments Each Year?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. Back out any income you have from your job (if you don’t want to work, skip this step), and any other income you may have. Then divide the figure by .04 to find out the assets it would take to support that level of annual income. (Why .04, you ask? Many financial planners calculate that an investor could withdrawal 4% of their money each year and the account would still generate enough, over time, to maintain its current value after adjusting for inflation.)
An example might help. Let’s say you want to make $80,000 per year to live the way you want. You only want to work part-time and figure you can make $20,000 per year. You expect to collect $15,000 per year in Social Security. You would take $80,000 - $35,000 = $45,000. Then $45,000 divided by .04 = $1,125,000. That’s the amount that would be required for you to earn the other $65,000 from your investments and never run out of money.
Now, you need to figure out how soon you want the money. Let’s say you are 35 and you want to retire at 65. That gives you 30 years. Using any one of the thousands of savings calculators online (check out this one from Bankrate, for instance: Savings Calculator), you can plug in your numbers and figure out what it would take in terms of monthly savings to reach your goal. Assuming you can earn 8% on your investments, it would require $754.85 put aside each month until you retired. (If you started at 25, instead, it would take only $322.26 per month due to the power of compounding. If you started at 18, it would only take $181.09 per month.)
If you don’t want to leave anything to your family, friends, or charity (a charitable remainder trust can be a great choice for investors), the savings figures would be much lower because this model assumes you maintain the $1,125,000 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.