When to use the 4% rule
When you hear the word “rule”, you may either feel a sense of relief, or rebelliousness.
You’d feel relief if you get security from knowing what the rules are. But if you don’t like to follow rules, just the mention of them may stir up your rebellious nature.
If you’ve struggled with money management in the past, following the right rules can keep you from making bad decisions. However, you really need to make your own decisions based on your personal circumstances. Most rules aren’t just one size fits all.
So whether you’re a rule-follower or a rule-breaker, it’s important to consider how any rule that claims to strengthen your financial security would fit with your situation.
One example is the 4% rule, which refers to the percentage you can withdraw from your savings without running out of money before you die. So, obviously, this is one of those rules that doesn’t work for everyone across the board.
It’s impossible for the 4% rule to include every possible scenario, so you need to determine for yourself if it’s a guideline that will benefit your own unique retirement goals.
When you think about your vision for retirement, consider those things you want to achieve. Do you want to be an international traveler, or live in an RV? Do you want a second home in the mountains, or be content with just a small apartment? Do you have goals for pursuing expensive hobbies, or will you stick with affordable ones?
It’s important to start from the end. Spend time thinking about what you want your retirement to be like, and develop a clear vision for your future. Knowing where you want to end up will be the best guide in getting there.
You may determine that the 4% rule is not the best fit for you. But knowing what it is, how it works, and its limitations will help you come to an educated decision.
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What is the 4% rule?
The 4% rule addresses the annual withdrawal rate from your retirement portfolio.
So, for example, if you have $500,000 in your retirement savings, the 4% rule states that you should withdraw $20,000 the first year you start to withdraw from your portfolio. Over time, you can increase this percentage to account for inflation. If inflation was 2% in your second year of withdrawals, you would increase the first year’s amount to $20,400 ($20,000 x 1.02).
The theory behind the rule is that your savings should last a retirement span of 30 years. So, it’s a tool you can use to make sure you don’t run out of money before you die. That’s a good thing!
But, there are a few significant variables that the rule does not account for – one of which is if you live longer than those 30 years.
The problems with the 4% rule
The 4% rule was first introduced by financial adviser William Bengen, who first published the results of his extensive research and simulations in 1994. He concluded, after a thorough examination of historical market behavior, that a person could withdraw up to 4% annually from their portfolio without outliving their savings.
This advice has been given to investors entering retirement for over 25 years because it’s been tested and proven successful time and time again.
However, the 4% rule makes specific assumptions that may not apply to your financial circumstances.
Here are a few features of the 4% rule that could present a problem to your retirement strategy:
- Investment mix: If you have any type of portfolio except 50% invested in stocks and 50% in bonds, you may not replicate the market’s overall return, which is what the 4% is based on. For example, if your portfolio is heavy in bonds rather than stocks, you won’t realize nearly the return the 4% rule was based on at a time when bond rates were much higher. If you stick to the 4% rule in this situation, you could be out of money before 30 years.
- Taxes: Unless all of your retirement funds are in a Roth IRA, you’ll owe taxes on your withdrawals, which eats away at the money you’ll have to live on based on the 4% withdrawal rate. You pay taxes on each 401(k) and IRA withdrawal because you realized the tax benefits when you first contributed.
- Market conditions: The 4% rule doesn’t take into consideration a failing market. If the market takes a nosedive shortly before you retire, then that percentage may not be enough to support you. If you decide to stick to the 4% rule based on your original projected portfolio, you may withdraw too much, leaving you with less than you need for your lifetime.
- Life span: Nobody knows their life span, so when it comes to retirement, the safest thing to do is plan for the longest possibility. Many financial advisers advise that you plan your strategy to support you until 95 years of age. If you decide to retire before 65, you put yourself at risk of going beyond the 30 years accounted for.
- Sources of income: If you will have access to income other than investment portfolios, you could probably apply the 4% guideline without fear of running out because you have supplemental income. However, you may be able to increase the rate – which would raise your standard of living – and still remain financially secure well into your older years.
In addition to these main points, you will likely have other, more subtle distinctions in your financial circumstances that will require additional consideration. You will want to examine the details closely as you approach retirement age.
Questions to ask for guidance
It might feel a little stressful trying to figure out how you won’t run out of money in your old age. After all, there are variables you have no control over.
The best way to be prepared is to overprepare. Save more than you think you’ll need. Plan to live longer than you think you will. Prepare for conditions that are worse than expected.
Also, ask yourself these questions to guide you:
- What sources of income will you have? Will your income strictly come from retirement savings that have tax consequences? Do you have other investments, pensions, or Social Security income that you can take into account? During the times that you have ‘other’ income coming in, you may only need 4% from your retirement savings. But if you retire early, you may need more until your ‘other income’ begins.
- How close are you to the age of 70 ½? This is a pivotal age when it comes to retirement income because the IRS requires you to take Required Minimum Distributions once you hit this age. How much you must withdraw depends on several factors including the age of your spouse. Most people will have to withdraw much more than 4%, though, in order to avoid tax penalties.
- What’s the market like? You’ll have to gauge this in the moment. If the market is down, you may want to pull back on the 4% rule, withdrawing even less from your retirement. If the market is up, though, you may find that taking out much more is feasible, while still leaving you with plenty of money for your remaining years.
- How much do you want to leave? Some women feel better leaving their heirs with money. While you should put yourself first, it’s okay to think of others too. If this makes you sleep better at night, you may want a different percentage than 4% to ensure that your loved ones are cared for, too.
Choosing your strategy
I always think a good approach to determining a strategy is to learn everything that’s inside the box before you venture outside the box. In other words, be familiar with the recommended rules, guidelines, and proven methods before you decide you want to forge your own path.
If you’re not much of a rule follower, you may want to come up with your own guidelines. Or you could simply want someone else to tell you exactly what to do. Most people will fall somewhere in the middle because everyone’s situation is unique.
The important thing to take into consideration is the risk you’re willing to accept with your retirement savings. You know your financial situation better than anyone else, so be sure you’re comfortable with the decisions surrounding your retirement income strategy.
Become an expert in your own finances. Then you’ll know what is right for you.
Talking with a financial planner, no matter what you decide, is one of the best things you can do to prepare for the future. It’s always a good idea to get input from an expert, and an unbiased opinion to see how you should move forward.
Your spending habits, savings habits, and retirement goals all play a role in your decision that will provide you with the most successful retirement. Circumstances will change over time, so as you create your strategy make sure you remain flexible and review your goals periodically.
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