Calculate your number: How much money you will need

- [Instructor] You can calculate your number much more accurately than any retirement calculator can. You just need to figure out how much money you'd need to have invested before you can live solely off a portion of your returns, while keeping some of your returns invested, so they can continue to grow. While the most accurate way to calculate your number is to determine how much money you will need to live on each year for the rest of your life once you do decide to retire, AKA your expected annual expenses, it's nearly impossible to do, because you don't know how your goals, desires, wants, and needs are going to change over the next 10, 20, 30, 40, or even more years. This is where the retirement calculators and financial planners fall short. They expect you to know how much money you will want to spend in the future and then base their calculations off of that number. But even for the best planners coming up with an exact target for your expected annual expenses in the future is completely unrealistic. The finance industry often sells a level of precision with investing and retirement planning that's really just guessing. They also don't focus on helping you determine how much money it would take to live a life you love, because you're the only one who can really do that. This is why I recommend you approach this more holistically, finding the amount of money you need to live today and adjusting it once a year, as you change and grow. With that in mind, I recommend using your current annual expenses to calculate your number for two reasons. Number one, if you plan to retire in the next few years, your recurring expenses likely won't change that much. Number two, it's much easier to figure out how much you currently spend than what you'll be spending 20, 30, or 40 years down the road. The easiest way to calculate what you spend in a year is to look at how much you've spent each month over the past 12 months in the categories outlined in a calculator that I've built for you at financialfreedombook.com. These categories include housing, things like your mortgage and rent, your property taxes, how much you spend on electricity, how much you spend on cable and internet, transportation expenses, like car payments, and maintenance and repairs, and gas, and insurance, things like flight and travel expenses, food, how much you spend on groceries and eating out, and other things, like how much you spend on clothing and food. Check out the simple tool at financialfreedombook.com/tools where you can make this really easy by pulling your own data directly from your accounts. You can also download the table in editable form and customize it yourself. It also might be worth it to do the calculation manually, so you can see how the numbers work and how they add up. Each quarter, I update a spreadsheet that looks like one page that you'll find at financialfreedombook.com, which includes a breakdown of how much the average American household spends in each of these categories each year. How do your numbers compare? Once you've figured out your expected annual expenses, you can calculate your base number. To do this, you'll need to draw on some of your sixth grade math skills to determine the amount of money you need to have invested before you can withdraw enough to cover your annual expenses. Written as a formula, the calculation is something like this, withdrawal rate percentage times your number equals annual expenses. Let's say you spend about $50,000 per year, like I do. Assuming you will be withdrawing at the recommended rate of 4% a year, your calculation should be something like this, 4% times your number equals 50,000, or written another way, $50,000 divided by 4% equals your number, which in this case would be $1,250,000, or written another way, $50,000 times 25 equals $1,250,000. While I personally use the 25 times rule, if you want to be a little more conservative, then I recommend using a 3.5% withdrawal rate percentage to provide a little cushion. In this case, the calculation would be $50,000 divided by 3.5% equals $1,428,571. If you plug $50,000 into an online retirement calculator, it will tell you that you need to save between 3 million and $4 million if you want to retire in your 60s. But based on a simple calculation, you find that you need less than half that to reach financial independence more than 30 years earlier. Obviously though, if your expenses increase or decrease, your number will too. Perhaps you currently don't make a lot of money and are living on $20,000, but you eventually hope to move out of your apartment you currently share with three roommates and intend to have kids one day, which will of course increase your expenses. Or maybe you have a dream of traveling or being able to buy that sweet vintage car. The higher your expenses, the higher your number, but even cutting back on a few of the expenses can reduce the amount of money you'll need, in some cases, significantly. The impact of a single recurring expense on your number, one simple way to reduce your expenses, and thus your number, is to calculate the impact that each recurring expense has on your number by following the simple equation your monthly expenses times 12 months times 25 times your annual expense multiplier equals the impact of that recurring expense on your number. Okay, I know that might sound a little complicated, so let me give you an example. For example, I spent over $350 a month in takeout food in 2017. So if that expensive habit continues, I will need $350 a month times 12 months equals $4,200 per year. Gosh, that's a lot of money on takeout food. And then if you multiply that $4,200 per year by 25 X, which is the early retirement multiple here, it would be $105,000. So in other words, I'll need $105,000 extra saved just to support my takeout-eating habit for the rest of my life. If I could just cut this figure down to $200 per month, then I would need $200 a month times 12 months is $2,400 per year, times 25 equals 60,000, or $45,000 less. Any type of recurring expense, things that you're spending each month or each year, is going to increase the amount of money that you need to retire. Adjusting your number for one-time, future expenses, while the 25 times multiplier helps you estimate how much you'll need for your living expenses, it doesn't factor in future one-time expenses that might increase the amount of money you'll need to withdraw. Most retirement calculators also aren't designed for you to estimate future one-time expenses, but you should estimate how much you might need at different stages of your life, and for one-time, big expenses, things like a kid's college education. If you have some big, one-time expenses in mind, you'll want to build them into your number either today or the next time that you adjust your calculation, as you change, and your life changes. Here's how. If you estimate you will need $80,000 for your child's in-state college tuition, room and board, you don't need to add $80,000 to your number, since you won't be paying that $80,000 in monthly installments for the rest of your life, or hopefully not. The way to add it is by estimating when you will need the money and determining how much you need to invest for it to grow to be $80,000 when you need it. For example, if your child is three years old today, you won't need that $80,000 college tuition money for the next 15 years. So you need to calculate how much you would need to save today at 7% expected annual compounding, so it will be worth $80,000 in 15 years, not today, using a really simple calculation, and one of the most valuable in personal finance, known as the present value formula. Don't worry, it sounds more complicated than it is. The present value formula measures the time value of money. So you can measure how much you need to invest today to get that $80,000 over the next 15 years. So I'm going to put this in as simple terms as possible. For this example of needing $80,000 for your kid's tuition in the future, you're going to start by taking the $80,000 and multiplying it by one over the expected investment growth rate, so in this case, 7%, to the power of the number of years that it has to grow, so in this case 15 years. So when you use this equation, you see that in order to have $80,000 in 15 years, with an expected growth rate of 7% per year, you would need to have $28,995.68 saved today. So you would need to save $28,995 today for it to be worth $80,000 in the future. You should add this to your number. Then after 15 years, you can withdraw the money you need for the college tuition all at once, or over time, and let the money keep growing. You should use this same formula to adjust your number for any one-time, big expenses in the future. Another factor that's a pretty big wild card is the future cost of healthcare, which is not only getting more expensive in the United States, but will also likely increase as you get older and need more care. This is why it's so important to plan and regularly revisit your number quarterly, or at least once a year to make adjustments. Don't worry, you'll be a pro at this in no time. No matter how big your number is, you might be thinking, "Whoa, how can I save that much money?" While $1,250,000 was a lot less than the 3.5 million the retirement calculators were telling me, I initially felt overwhelmed. That's a lot of money to save when you're broke. I started wondering if I really needed that much money at all. Ultimately, how much money you need depends on one big variable, the lifestyle factor. While you're calculating your number, and analyzing your expenses, it's the perfect time to take a hard look at your current spending and evaluate whether you need to spend that money to live the life you want. Obviously, the lower your expenses, the less money you'll need. Also, the lower your expenses, the more you can save and invest, and the more you can invest, the quicker it will grow, and the faster you can reach financial independence.