Trying to figure out how much you should save for retirement or how long your savings will last? In today’s post, we are going to look at the 4% rule and how to use it to determine how much you should be saving or if you are ready for retirement.
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What is the 4% rule?
When it comes to saving for retirement, it seems there are a ton of “rules” to understand. Every financial professional has a different perspective on what you need to do in order to thrive in retirement or how long your retirement savings will last. It can be confusing to sort through all the data at your disposal and identify how much you must save to retire.
Many financial professionals, bloggers, and money experts recommend using the 4% rule. It may sound simple to understand but let’s take a deeper dive.
The history of the 4% rule
In the early 1990s, financial planner William Bengen can up with the 4% rule. He tested a variety of withdrawal rates on several different portfolio allocations using return and inflation data back to 1926. He discovered that the ultimate withdrawal rate would be 4% assuming a 30-year term.
He established that each retiree would take 4% their first year and then adjust for inflation in the years remaining.
Many people assume that with the “4% rule” you withdrawal 4% of your total portfolio value each and every year in retirement. This isn’t the case. Your first year in retirement you will withdrawal 4% and then adjust for inflation every year after that.
For example, let’s say you have a portfolio of $1 million and inflation is 2%. Upon your first year of retirement, you would take out $40,000. Then your second year you would take out $40,800. Then your third year you would take out $41,600 and so on.
Keep in mind, the 4% rule doesn’t guarantee you won’t run out of money or that your retirement savings will last. However, if you stick to a pre-determined withdrawal amount, it can provide a level of confidence that your portfolio will support you at least 30 years.
How dividends and taxes play a role in the 4% rule
The other two factors worth mentioning are taxes and dividends. Many retirees assume they should take their dividends as well as 4%. This is incorrect. Retirees should factor in their dividends into their 4%. If we use the example above, and you received $15,000 in dividends in your first year of retirement, you should only distribute another $25,000.
The same goes for your taxes. You should still only distribute 4% of your total portfolio and pay the taxes on that sum. Let’s say your federal tax rate was 24%, you would then need to withdrawal $52,600 to account for taxes. This would mean that your withdrawal rate would be 5.3%. This percentage might not allow you to maintain your portfolio for the longevity of your life.
How much should I have saved for retirement?
The four percent rule is a popular formula for figuring out how much you should save for retirement. Let’s say for example you wish to retire on 40K a year income from your savings, then you would need to save 1 million dollars. (Easy enough, Right?)
Tip: An easy way to determine how much you will need to save using the 4% rule is it to multiply your desired income by 25. I.e. 40k times 25 = $1,000,000.00
Why 4%? Why not 5, 6, 7%
The 4% rule was determined to have the highest probability of not running out of money based on historical market conditions. Even at just 4%, the rule doesn’t guarantee 100% success that savings will last, because of this academics debate the validity of the 4% rule.
Some believe the 4% rule is too conservative, while others like Ibbotson believe the 4% rule should be revised to a lower withdraw rate to adjust for today’s lower interest rates.
Why the disagreement?
No one knows for certain what type of returns a retiree will experience. A retire who retires when stock valuations are low may experience above-average returns in retirement and may be afforded the opportunity to take much higher withdrawals.
The retiree who retirees at the peak of the market, may be more inclined to experience a market downturn or low growth in retirement, and may find even modest withdrawals deplete their nest egg.
The 4% rule doesn’t work for everyone
Michael Finke, Ph.D., CFP®; Wade D. Pfau, Ph.D., CFA; and David M. Blanchett, CFP®, CFA suggest that retirees may want to aim for a 3% rule. However, even with this rule, there is a 20% failure rate.
On the other hand, Michael Kitces highlights that since the late 1800s that bond yields may have been low but stocks performed horribly. Yet, he still notes that if a retiree uses the 4% rule with a portfolio invested in 60% stocks and 40% bonds, they would end up with double the amount they started with after 30 years.
So, what’s the point? It’s impossible to predict the market and future returns. This makes it even more unlikely that you can predict your withdrawal rate.
Making your retirement savings last
Listening to experts who disagree can make you feel hopeless. If you must save over a million dollars just to earn a modest income, an eventual retirement may seem unattainable.
However, all is not lost; you may not need to save as much for retirement as the calculators suggest. You just have to be more efficient with your money.
- Consider a tax plan to minimize taxes in retirement. Every dollar you can avoid in taxes is less money that needs to be withdrawn from your portfolio.
- Consider the best timing of Social Security benefits. Contrary to popular opinion waiting to 70 may not be the best plan.
- Invest in ways to reduce costs and minimize expenses. Saving money is often times more efficient than trying to earn more money.
- Invest differently. Consider alternatives to bonds in the portfolio like M.E.C’s and Fixed Indexed Annuities. These contracts have shown to generate higher returns than bonds with less drag on the portfolio when markets are rising.
- Diversify your income sources. Consider alternative ways to increase your income in retirement; such as the numerous ways to make money online, or even a hobby farm or side business.
- Develop a financial emergency preparedness plan. The most significant risk to your retirement is a financial emergency dictating that you withdraw funds are an inopportune time.
The bottom line
Whether you decide to use the 4% rule or not, you need to determine a withdrawal rate that will work for you. Even if you don’t know how your investments will perform, you need to make a plan for your retirement. The more prepared you are, the more likely your portfolio will last through your entire retirement.
Evaluating all the aspects of your financial life will help you determine what’s the right plan for you.
This article was originally published on Your Money Geek.
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