The Retirement Savings Number That Could Matter More Than Your 401(k)

As you're saving for the future, you might worry that you need to catch up on your retirement savings. You may even check on your 401(k) balance every quarter or so to ensure you're on track to meet your target, with many people picking a totally random 401(k) target number – often $1 million – that feels large enough to meet their long-term financial needs. However, you should perhaps instead be focusing on your income replacement ratio. This ratio is the portion of the income you had while working that you need to replace with your retirement income to maintain the lifestyle and standard of living you had while employed.

Simply picking a target savings figure for your 401(k) balance doesn't take your financial standard of living while working into account. Using this ratio gives you a more personalized projection of your financial needs in retirement, allowing you to better strategize for exactly how you can live your golden years out in comfort. Ultimately, without putting some thought into your individual income replacement ratio and whether you're on track to meet it, you might not be financially ready to retire.

To calculate your income replacement ratio, divide your gross income after retirement by your gross income before retirement. Then, multiply the result by 100 to generate a percentage. As an example, if you made $100,000 annually when working, and the annual gross income you'll have after retirement is $75,000, you'll have a 75% income replacement ratio. A common target people use for an income replacement ratio is 75% of their monthly spending while working. However, some people can retire comfortably at 65% or less, while others may need more than 75% of their pre-retirement earnings to maintain their standard of living.

To get a sense of your retirement income, you'll want to factor in things like your 401(k) account balance and how much you can reliably withdraw from it each year, alongside your expected Social Security income at the age you want to retire and any pensions, investments, or other assets you're taking into retirement.

Most people naturally change how they spend after retiring, and doing your best to factor these adjustments into your income replacement ratio calculations can be extremely helpful. For example, you could subtract any expenses you have directly related to working from your gross pre-retirement income and add that money to your estimated gross income after retirement. Similarly, if you foresee that you'll incur any new expenses as you age that you didn't have while working, you may need to make some additional subtractions from your projected post-retirement gross income to compensate for them.