Determining your annual retirement expenses and savings goals can be difficult when you still have several years left to work.
Many retirement planners and retirees use the 4% rule to estimate their yearly retirement withdrawal rate to make the planning process easier.
Here is a closer look at how the 4% rule works.
What Is the 4 Percent Rule?
The 4% rule projects that you will withdraw up to 4% of your retirement savings for expenses during your first year of retirement. Then, you adjust the amount to account for inflation each year after that.
This safe withdrawal limit can help you save up to 30 years of cash reserves.
Financial planner William Bengen is credited as the rule’s inventor. Financial advisors have been using it for approximately 30 years.
In the original rule, Mr. Bengen’s model investment portfolio included 60% large-cap stocks and 40% intermediate-term Treasury bonds.
In most instances, the 4% rule can help make sure you don’t outlive your savings. However, you may need to adapt your investment strategy to the current market conditions.
4 Percent Rule Example
The 4% rule is easy to calculate. You simply plan on withdrawing up to 4% of your retirement savings each year.
To estimate how much you can withdraw each year using the 4 percent rule, use this formula:
Retirement Savings Balance X 4% (0.04) = Your Annual Withdrawal Limit
For example, if you have a $1 million nest egg, you can withdraw up to $40,000 in your first year of retirement.
Formula: $1,000,000 X 0.04 = $40,000
You will need to repeat this calculation each year since your portfolio value will change.
You might be ready to retire if you anticipate annual retirement expenses to remain below the 4% calculation.
The 4 Percent Rule and Inflation
Inflation will require you to increase your year-over-year withdrawals to keep up with rising costs. Thankfully, it can be easy to calculate your next year’s withdrawal using the current inflation rate.
Let’s say the current inflation rate is 3% and you withdraw $40,000.
You can multiply your current annual withdrawal amount by 1.03 to calculate a 3% increase.
$40,000 X 1.03 = $41,200
For planning purposes, you will need to withdraw $41,200 to cover the same expenses that $40,000 currently covers.
You will also need to track your current portfolio value to determine if your investment growth keeps up with inflation and expenses.
When Should You Use the 4 Percent Rule?
Here are some instances when the 4% rule can help you plan for retirement.
Determining Your Annual Withdrawal Rate
Being able to plan your annual withdrawal amount easily can be the best reason to use this rule.
The 4% rule can help you quickly estimate a safe withdrawal rate during retirement.
If the rule suggests you withdraw up to $40,000 per year, that means your average monthly expenses are $3,333.
You can efficiently determine if your estimated monthly expenses are above or below a 4% withdrawal rate.
If your expenses are higher than your withdrawals, you will need to increase your retirement account balance to reduce your withdrawal rate to 4% or less.
Accommodating for Inflation
You can maximize this rule by withdrawing 4% the first year and then base your future withdrawals on the annual inflation rate.
Inflation varies from year to year. Some fixed withdrawal retirement strategies may not account for inflation, and you only find out later that you withdrew more than your original calculation.
Using a 60/40 Asset Allocation
The rule assumes your retirement portfolio holds 60% stocks and 40% bonds.
This is a popular asset allocation strategy, and several robo-advisors can automatically build this portfolio with index funds for minimal fees.
Your preferred asset allocation may vary slightly from the 60/40 target. However, you will still hold more stocks than bonds.
A 60/40 portfolio can help you enjoy the growth potential of stocks and earn recurring investment income from bonds.
Keep in mind that this portfolio has moderate investment risk but may be too aggressive for the most risk-averse retirees.
Utilizing a Roth Retirement Plan
Not having to pay income taxes on your retirement distributions minimizes your retirement expenses.
As a result, it’s easier not to exceed the 4% withdrawal target because of higher-than-anticipated expenses, including taxes.
Let us know in the comments below if you are using the 4 percent rule for your retirement account.