The 4% Rule: Does It Still Apply for Your Retirement?
One of the biggest questions of retirement is "Will my money last? Or will I go broke before I die?" As morbid of a question as that seems, it is a real financial problem to consider. You've worked your entire life and diligently saved up for retirement. Your nest egg has grown to hundred of thousands of dollars, or maybe even millions. But will it last?
A common solution touted as one of the basic tenets of retirement is the 4% rule.
Photo by Ralf Peter Reimann via Flickr
What is the 4% Rule?
The 4% rule is the idea that in your first year of retirement you should withdraw 4% of the balance of your nest egg for your retirement income needs. In subsequent years you should adjust the amount you withdraw based on inflation increases.
If you retire with a nest egg of $2,000,000 you would withdraw $80,000 in your first year of retirement. If inflation increased 2% during the year, the next time you withdrew funds you would withdraw $81,600 and be able to maintain the same lifestyle that you had the year before.
Does the 4% Rule Work?
Looking back at history if you had retired and started using the 4% rule, your chances of running out of money in your retirement portfolio were very slim even if you lived 30+ years in retirement with no additional income coming in.
Why the 4% rule seems to work is the level of income you withdraw every year. If you have a diversified retirement nest egg, you likely have a large portion of bonds in your portfolio. Those bonds kick out interest income that can range from 2% to 5% for most investments. If a majority of your portfolio is in this type of investment, you are primarily withdrawing interest income instead of principal out of your retirement account. You are minimizing the impact of your withdrawals on the core of the portfolio, which allows it to continue to grow over time.
Will the 4% Rule Always Work?
Just because something is called a rule doesn't make it a law of the universe. Therein lies the problem with the 4% withdrawal rule -- it doesn't always work. The amount you can withdraw from your retirement accounts fluctuates based on your investment mix and their performance.
Retirement Income Withdrawals During Bad Years
If you are heavily weighted toward stocks at the beginning of retirement and the stock market nose dives down 25%, your nest egg just took a massive hit. If you can survive on withdrawing little cash while your portfolio recovers, your money will last longer. You want to avoid withdrawing funds when you've recently lost money.
Retirement Income Withdrawals During Good Years
Likewise, if your portfolio jumps 25% at the very beginning of your retirement you could likely enjoy some extra income in the following years because you got an unexpected boost.
How Much Should I Withdraw for Retirement?
To determine how much you should withdraw during retirement you need to look at three main factors: your plans, your health, and your investment performance.
Consider Your Plans and Health
If you want to be able to enjoy your nest egg while you are still able to, it might make sense to have a different withdrawal strategy where you withdraw a larger percentage in the first 10 years of retirement before drastically ramping down your income in later years. There is nothing more tragic than someone who retires with a huge nest egg, but never goes out and enjoys it for fear of running out of money before they die.
Likewise it is equally tragic when someone does run out of money before they die, and the last few years of their lives end up being very painful or reliant on family to support them. Retirement is a balance, and you must find yours.
Consider Your Investment Performance
A simpler rule would be to start discussing your withdrawals at the 4% mark, but adjusting each year based on investment performance. In good years you can get away with taking a bigger payout and in bad years it makes sense to cut back. If you retired in 2007 right before the financial crisis and found yourself in good health, it made sense to cut back on your withdrawals while the market -- and your portfolio -- recovered.
It's All About Balance
Just like you handled your pre-retirement years with a budget of income (from working), day to day expenses (your mortgage and utilities), and planned expenses (your summer vacation), you need to manage and budget your retirement income. If you were working and found your income down for 6 months, you probably adjusted your monthly expenses as much as you could to adapt to the lower income. The same must be done in retirement. If your portfolio takes a huge hit, it is time to cut the big vacation from this year's plan and move it to next year.
Life is about balance, and that doesn't stop when your paychecks go away. Be wise with your nest egg, it's the only one you're going to get.
This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.