Everyone wants to know: “How much money do I need to retire?” There are a million answers, most starting with “Well, that depends…” But honestly, it’s not that hard to figure out.

It starts with two simple principles that apply to almost everyone:

Principle #1: You want a post-retirement lifestyle similar to your pre-retirement lifestyle (but with less work and more margaritas).

Principle #2: You can make slight adjustments to your living expenses if needed, so your numbers don’t need to be precise — just close.

With these principles in mind, we’ll calculate what your retirement expenses will be and see how much of them are covered by guaranteed income like Social Security and pensions. If you can cover them all, you’re as lucky as a leprechaun (and about as rare). If not, we’ll figure out how much savings you need to cover the rest.

For this exercise, let’s assume you plan to retire at age 66 or 67. That means you have Medicare for insurance and full Social Security benefits. If you choose to retire earlier, you’ll need more money.

Note that the charts below are based on a typical married couple of similar age — but with a pencil and a little initiative you can make it work for almost any circumstance.

[Scroll down to “The Shortcut” if you want to skip the math]

Let’s start with annual living expenses

Go grab a paycheck, figure out your annual take-home amounts (not the gross), and subtract the amount you put into savings (since that’s not necessary in retirement).

Now let’s adjust that number slightly:

1. Many experts say retirement costs 20%-40% less, and your expenditures will decline even further over time. No commute, no life insurance, fewer new clothes, cars, shoes, and dinners out. You’ll probably pay off debt and maybe even downsize your home. If you can’t decide exactly how much to subtract, 20% is a good choice.
2. Will you make significant changes to any pre-retirement spending habits such as travel or hobbies? Add or subtract accordingly.

Now you have a starting number — write it down. That number represents the annual living expenses in your initial years of retirement — except taxes. Can’t forget taxes — we’ll add them in later.

Annual recurring income

Recurring income streams are those regular payments you’ll get from Social Security and pensions. It’s easy to look up your SS benefit. Go here to find yours and if you’re lucky enough to have a pension, check with your employer or plan administrator to get that number.

Subtract that from your living expenses. The remainder will come out of the growth and principle from your savings and investments.

Savings and investments

This largely includes investments such as IRAs, 401k’s, mutual funds, and conventional savings accounts. Look them up and jot down the amounts.

There are a few other sources you may want to consider but be very careful about counting money you don’t have. Running out of savings late in life can be catastrophic. Inheritance amounts and timing are impossible to pin down and tapping into home equity is considered a high-risk strategy.

About taxes in retirement

Most of your retirement income will be taxed. Generally speaking, 85% of Social Security income is taxable. Most pensions are funded with pre-tax dollars so are also taxed. Interest income is taxable. 401k and traditional IRA withdrawals are taxable. Savings and Roth IRA distributions are among the rare income sources not taxed.

How much federal income tax do you need to account for? Let’s estimate it now:

Your “effective tax rate”, as shown in the [married couples] chart below, is the result of applying progressively higher tax rates to different income layers (brackets). The first layer is taxed at 10%, the next layer at 12%, then 22%, and so on all the way up to 37%.

This means that even though you may be in the 22% tax bracket, when you add up the tax amounts from each of the lower layers, the effective tax rate will be less — somewhere between 11.5% and 17.1%.

State taxes matter too. Seven states have no income tax but the rest have a patchwork of rates and methods. You’ll have to look them up and add that to your effective rate. You can find information about state income tax rates here or by a quick online search.

Since most of your income will be taxed, start with 90% of the retirement take-home that you calculated in the first step. Then deduct $27,000, which is the standard IRS deduction for a couple age 65 or over. Multiply that amount by your effective tax rate and see how much the governments take.

Add that to the remainder. That’s your final number.

Here’s what we just did:

1. We calculated what you’ll spend in retirement and subtracted the amount covered by recurring income streams
2. We took the remainder and added taxes
3. That final number is the total amount you need to cover with savings and investments

What’s your magic number?

Your final number is the true amount of money each year that savings and investments need to cover, if you wish to live in the manner to which you’ve become accustomed.

So, take that final number (remainder plus taxes) and multiply it by 25.

That’s it! Now you have your magic number! The total amount you need to retire.

The multiplier, 25, is based on the 4% rule which says you can safely take 4% plus inflation from your savings each year in retirement and be confident it will last for 30 years or more. Some market-savvy investors prefer to use 20 which represents a 5% return, but we’ll use 25 to be safe.

The shortcut

If I lost you at “go grab a paycheck”, you can use the chart below for some guidance. It uses all the assumptions and calculations discussed above to illustrate a possible solution to the question of “How much do I need?”

Pick a “Current Annual Living Expenses” row. The blue bar estimates how much income could likely be covered by recurring income streams like SS or pensions. The orange bar estimates the leftover amount that needs to be covered from savings and investments.

The corresponding red number is a good target for “how much you’ll need.”

So… do you have enough yet?

Remember this example is for a 66 to 67 year old married couple of similar age, planning to retire soon.

How do you compare?

If you’re on track, congratulations! Now’s a great time to celebrate with that margarita I mentioned.

If you’re a bit behind on your goals, take comfort in the fact that you’re in good company. The median retirement savings for people approaching their 60’s is less than $100,000.

So what do you do if it looks like you’re coming up short? Don’t worry — there are plenty of options:

• Keep working and focus on stashing away as much as you can. Take a look at your current living expenses and slice and dice your way to a higher savings rate.
• Recognize the difference between “Need” and “Want”. I want to live in the style to which I’m accustomed. I need food to eat and shelter to keep the rain off my head. Focus on your needs.
• You may decide to work part time in retirement. Again, you’re in good company — more than a third of retirees in their 60’s are enjoying a part-time encore career. A post-retirement career provides purpose, engagement, and slows the drain of limited funds.
• Cut costs. Why not downsize now — no need to wait for retirement. Or you may consider living out some of your retirement years where the costs are less. Mexico, Portugal, and Panama are beautiful countries with a lower cost of living. There are plenty of wonderful places in the US and Canada as well. Ask Mr. Google and he’ll tell you where to look.

Regardless of your situation, you can make your retirement the dream you’ve always wanted. It just takes a little planning.

Good Luck!

NOTE: The author is NOT a licensed investment professional; he’s just a clever guy who spends a lot of time researching and planning for retirement. Whenever you make investment decisions be sure to consult multiple sources and views, be as conservative as you can, and remember to … SAVE!