How to Use the 4% Rule For Your Retirement Plan

The “4% rule” is a key concept in the huge topic of retirement. How much money should you have in savings for when you retire?

While there is plenty of advice on how much to save for retirement, it's not clear how much you will actually need once you retire. This is the reason for the 4% rule.

What is the 4% rule?

The 4% rule, which is a general rule of thumb, suggests that retirees can withdraw as much as 4 percent of their savings in the year they retire. After that, adjust for inflation every year for a period of 30 years.

The 4% rule is not a strict rule, but a general rule of thumb. There are many factors that influence safe withdrawal rates such as risk tolerance and tax rates. These include tax rates, tax status (i.e. the ratio of tax deferred assets to taxable asset to tax-free assets), inflation, and tax rates.

This rule's simplicity is the best thing about it. It's much easier to plan when you have a clear and concise guideline for retirement spending. It has some downsides, such as the possibility of it becoming outdated before you reach retirement. Also, any flat number does not adjust for market conditions which will surely change from year to year.

Let's look at the 4% rule more closely. We'll see if it can be used as a guiding principle for retirement planning, or if it is ill-equipped to handle the dynamic set factors that will determine long-term savings over future spending.

The history of the 4% rule

William Bengen, a financial advisor challenged the old belief that 5 percent per year was safe when he used historical data from stock and bond returns for a period of 50 years (1926 to 1976).

Bergen analyzed the half century of market data and concluded that almost any economic scenario, even the most turbulent, would allow for a 4 % withdrawal in the year they retire. Then they'd adjust to inflation every year for the next 30 years.

Bengen used a 60/40 portfolio (60% equities, 40% bonds), and it was done during a period with higher bond returns (higher interest rate) than current rates.

The 4% rule does not account for these things

While we can't dismiss William Bengen's hard work and the financial community's support for his conclusion, it is important to remember that the 4% rule does not account for every person's unique situation. This isn't a failure in the rule or the math behind it, but an inherent flaw in attaching any flat rule to long-term financial planning. The economic landscape is complex and not flat.

These are some of the reasons why opting for a flat 4% withdrawal rate in retirement is not an option:

  • Medical expenses: They will be there as we age, especially during our golden years. But it is hard to know what type of medical expenses we'll have to pay. Others are more expensive than others. Life expectancy is another factor that can impact the viability and longevity of the 4% rule. It's obvious that the longer you live the more you will need to save.
  • Market fluctuations: It is likely that the economy will fluctuate throughout your retirement years. If the economy is booming, it might be fine to withdraw more than 4% per year. However, in uncertain times, you may need to reduce your spending. There is no set rule that will guide financial management. It's better to keep an eye on your finances and act accordingly.
  • Personal tax rate: This is a big factor. It is affected by many factors, including your investment accounts, your income, deductions and credits, as well as your state of residence.

Do you need to use the 4% rule or not?

These personal, and sometimes completely unknowable details about our financial futures make the 4% rule inapplicable. Not at all. You just need to adapt it for your personal use.

That's the essence of both the 4% rule as well as any other financial rules: It is less of a directive on what you should do, and more of an informed starting point from which to create your personal retirement savings plan and spending plan. Although it doesn't cover all aspects of retirement finances, many people find it useful as a starting point.

However, where you invest your retirement assets will determine if the 4% rule is applicable. The 4% rule won't apply to you if your retirement savings are not based on a portfolio that consists primarily of stocks or bonds. Depending on how your portfolio is divided between bonds and stocks, 4 percent may not be the right number. It might make sense today, but it may not be appropriate in 20 or 30 years. It's up to you and your financial advisor to determine what the best projected withdrawal rate is.

This is our disclosure:  This summary is for informational purposes only. This summary is not intended to be a recommendation for or give advice for any company or individual.

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Nicole Jolie

Nicole Jolie brings you updated information on retirement including where to travel, health, investment trends and planning.  Whether you're a GenX'er, Baby Boomer or about to retire this site is for you.


This is our disclosure:  This summary is for informational purposes only. This summary is not intended to be a recommendation for or give advice for any company or individual.

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