Personal Finance

To Live On Savings, First Figure How Much You'll Need

Trent Hamm
Roy Hsu | UpperCut Images | Getty Images

You'd be surprised how often I'm asked this simple question. It's something on a lot of people's minds, apparently. How much do I have to save up to be able to live off of my own savings?

It's impossible to come up with an exact number, but we can come up with an estimate.

Figuring this out takes a little bit of math, so I'll walk you through some of the steps. First, let's talk about assumptions.

Let's assume that inflation is going to average 3 percent a year going forward. You can argue about that one all day long, but we're using a rough estimate here. Similarly, let's assume that you can invest in an index fund that will return 7 percent on average each year, but when you move to living off of your investments, you'll want to diversify into other investments, perhaps returning only 5 percent each year. We're also going to assume you're debt free.

The first thing you need to know is how much it actually costs you to live for a year. What are your actual living expenses for a given year?

The easiest way to estimate this is to request a statement from your bank for the year 2012 and total up all withdrawals from that account. That's your total annual expenditures for a given year.

Now, add 20 percent to that total. For example, if you calculated your annual expenses as being $20,000, add another $4,000 to that total, bringing you to $24,000.

After that, take that amount and multiply it by 20. The 20 number comes from the 5 percent estimate for long-term savings mentioned above. That's how much you'll need in the bank to reasonably live off the interest, starting right now. You would simply take out your living expenses each year and let the rest roll back into the account, protecting you from inflation.

So, if your target number is $24,000, you'll be shooting for $480,000. It seems like a lot, doesn't it?

The next thing you need to know is what percentage of your living expenses can you save each year? Can you save 10 percent? 20 percent? 50 percent? The larger the percentage you can commit to each year, the faster retirement will come.

Let's say you can commit to 40 percent of your living expenses each year – $8,000 in the example above.

After that, you're going to want to fire up a investment return calculator. Using that calculator, you'll put in an $8,000 annual investment and leave the rest of the defaults in place – a 7 percent rate of return and a 3 percent inflation rate.

Hit submit with that calculator and you'll see that it will take 25 years to reach $480,000. (A quick note – this calculator automatically does the inflation adjustment for you.)

Bump it up to 50 percent annual savings? You cut the target date down to 22 years.

Seems painful to reach, right? There are still a few factors working in your favor.

First, you'll presumably earn more in future years. This will raise the amount that you will be able to put away each year, bringing the date of living off your savings forward. With hard work, you can bring that number well under 20 years and start heading for the 15 year mark.

Second, you get to choose the lifestyle you live. If you inflate your lifestyle with more spending, you push that date into the future. If you keep things low-cost in perpetuity, you're off the grind even sooner.

Finally, this doesn't have to be a full income replacement. It can just be an avenue to try lower-paying career paths, for example.

Always remember that lifestyle inflation and laziness are your two enemies when working toward a goal like this one. Every bit you inflate your lifestyle puts off the date you can just walk away from work, and the same is true for apathy towards your work.