Long-term goals are achieved in more than five years. When you are figuring out the total amount you need to save for a long-term goal, it is important to consider the effect of inflation, which, as mentioned previously, is the general increase in the price of goods and services over time. Ever hear someone lament about how a loaf of bread, gallon of gas, movie theater ticket, etc., only cost a quarter back in the day? Well, inflation is one of the reasons those things cost multiple quarters now.
Start by researching what the cost of the goal is now. Next, figure out the rate of inflation you will use. (You can do research on what the inflation rate has been historically for your goal, but if you can’t find anything specific, you can use the general inflation rate (typically measured with the Consumer Price Index), which in recent years has hovered around 3%. Don’t worry too much about coming up with a precise inflation rate – even economists sometimes disagree on what to use.) To determine what the cost will be at the desired achievement date, use the “What will my investment be worth in the future?” calculator. (Enter the inflation rate in the “Rate of return” box, and leave the “Compounding period” at annual.)
Keep in mind that the cost of your goal is the after-tax amount that you need. In many cases, the taxes that you have to pay on your savings may be minimal or nonexistent. However, if you are saving the money in a tax-deferred account, like a 401(k), or expect significant earnings from a taxable investment, then it is a good idea to figure out the pre-tax amount and use that figure when calculating how much you will need to save each month. Doing this will ensure that you have enough money for both your goal and taxes. If you do not know what your tax liability will be, you may want to seek the help of a financial planner or accountant.
Once you know the total amount you need to save, you can figure out how much you should set aside each month. As discussed previously, it is a good idea to factor in the return that you expect to earn on your investments. For example, if you put money in a certificate of deposit (CD), you will be paid interest. If you invest your savings in stocks, the value of the stocks will likely increase over time, and you may also receive dividends. (Investment options are discussed in more detail later.) Some investments may come with a fixed rate of return that you know ahead of time. If what you plan to invest in doesn’t, you will have to estimate what you expect the return to be. One way to do this is to look at what the return has been in the past – past performance is not always a very good predictor of future performance, but unless you have a crystal ball, you may have no other choice. You can use the “How much should I save each month?” calculator to, as the title implies, determine how much you should save each month. If you have already saved some money for your goal, put that amount in the “Balance on start date” box.
You plan on buying a house in seven years. You would like to have a down payment of 10%. You look at home listings on-line and see that the homes you are interested in cost around $200,000. You have already saved $5,000. A real estate agent tells you that home values in your area typically increase about 4% a year, and you plan to put your savings in a mutual fund with a historical return of 5%. The current value of the desired down payment amount is $200,000 x .1 = $20,000. You use the “What will my investment be worth in the future?” calculator to determine the down payment amount you will need in seven years. You enter today’s date in “Present date”, today’s date plus seven years in “Future date”, $20,000 in “Present value”, 4% in “Rate of return”, and leave the “Compounding period” at annual. You get an answer of $26,318.64. You then use the “How much should I save each month?” calculator to determine how much you should save each month. You enter $5,000 in “Balance at start date”, 5% in “Rate of Return”, $26,319 in “Savings goal”, and 7 in “Number of years”. You need to save $192 monthly to reach your goal.
Your child will be going to college in 10 years. You would like to pay for half of his tuition costs. You look up the current tuition at several schools. The average is $24,000 a year. You plan to put the money in your state’s 529 college savings plan, which in the past has earned an average return of 6%. You have not saved anything yet. Future college tuition can be easily estimated with the “College Cost Projector”. The tuition inflation rate (which is typically much higher than the general inflation rate) is already provided – you just need to fill in whether it is a two- or four-year college, current one-year tuition costs, and years until matriculation (start of college). (Leave “Adjust tuition after matriculation” at yes.) Entering your information in the calculator, you get a result of $209,616.96 for the total projected tuition costs (assuming an inflation rate of 7%). Thus, the amount you want to save is $209,617 x .5 = $104,809. Using the “How much should I save each month?” calculator, you determine that you need to save $640 a month to reach your goal.
You are planning on retiring in 35 years. Other than that, you have no idea where to begin. Determining how much you need to save for retirement is no simple task. In addition to considering inflation and rate of return on your investments, you also need to consider what you expect your expenses to be when you retire, how long you expect to live, how much taxes you will have to pay on withdrawals, and what your Social Security benefits will be (or if you even want to count on receiving Social Security). Your best bet is to use a retirement calculator (a detailed one is available on the AARP’s website) or consult with a financial advisor.