Should You Use The 4% Rule To Create An Income In Retirement?

Most people have two major concerns about their retirement – whether they have saved enough and running out of funds.

Planning ahead of time is essential when it comes to the amount of money you have in your retirement fund when the time comes. 

But, it’s equally important to plan your withdrawals ahead of time to make sure you’re not going through your funds too quickly. 

While figuring out how much to withdraw can seem overwhelming, tools like the 4% rule can help simplify the process. 

What Is The 4% Rule?

The 4% rule is designed to help ensure you don’t run out of funds over the next 30 years. Using this rule, you’ll withdraw 4% of your retirement savings the first year you retire. Each of the following years, you’ll withdraw the same amount as your first withdrawal, adjusted for inflation. 

But why withdraw this specific amount? 

Well, in the mid-1990s, there were two studies done that really started this all.

The first was done by William Bengen, a now-retired financial advisor. The second was called the Trinity study, and it was conducted a few years later.

What each of these studies was trying to do is figure out how much you could take out of your portfolio, without subjecting yourself to a high risk of depleting your portfolio before your retirement was over.

Now there are some differences in the studies, like which type of bond funds will you use (five-year intermediate bonds vs long-term high-grade corporate bonds) – which we really won’t get into the weeds here today.  And they came up with slightly different, but very close withdrawal rates that would be sustainable.

Bengen originally came up with a 4.15% distribution, while the Trinity study came up with 4%.  And the 4% rule was born from that.

The main point of each of those studies is that they conclude that there were no historical cases where withdrawing 4% annually would deplete a retirement fund before 30 years.  And even at a 35 or 40-year retirement, the odds of depleting these funds would be pretty low. 

Based on these studies, the 4% rule has become a common tool in determining how much to withdraw each year of retirement.  It has been studied considerably since then and has held up quite well in subsequent years and testing on new and different time periods.  

How Does the 4% Rule Work? 

The easiest way to understand the 4% rule is by using an example. Let’s say you have $1,000,000 in retirement savings, and you want to use the 4% rule to figure out your withdrawal. The first year you’ll withdraw $40,000. Then, you will continue to withdraw $40,000 each year from your retirement fund. 

Then you increase the amount withdrawn each year to keep pace with inflation, accounting for rising costs of living. Therefore in our example, if inflation in year 2 is 3%, the total withdrawal amount would be $41,200.  And then it would rise again in year 3, 4, 5, etc.

Using the 4% Rule Over Time

The idea behind the 4% rule is that when you withdraw this amount annually, you will not run out of retirement funds within the next 30 years. This is not guaranteed, but it is highly probable. The issue with this rule is that it is based on several assumptions. 

The first assumption is how long retirement will be. It is assumed that retirement will last approximately 30 years. However, in today’s society, many people have a longer retirement. In such cases, the 4% rule may leave you short in your later years of life. 

The rule also assumes a specific portfolio composition of 50% stocks and 50% bonds. Any different composition means a different return, influencing how much you can comfortably withdraw. If you have a greater percentage of stocks, which historically have performed better than bonds in terms of rates of returns, you may be able to withdraw a higher amount each year without running out of funds. 

It also assumes that all dividends earned will be reinvested to keep your portfolio growing even after you’ve retired. 

Additionally, it is also assumed that market returns will match historical data. It should go without saying, I have no idea if that will actually happen!  If there is a low return period, such as an extended economic recession, your ability to withdraw the 4% annually may be negatively affected.

Understanding the limitations these assumptions can have, researchers revisited the effectiveness of this rule in 2011. The conclusions were nearly the same, with data suggesting that a 4% withdrawal continues to be an adequate figure to ensure funds don’t dry up. 

Applying the 4% Rule in Retirement

In theory, the concept behind the 4% rule is good. It can help give you a starting point to figure out how much you should withdraw from your retirement account. However, this amount may not be sufficient since there are several factors it does not consider.

One factor is the taxes to be paid on the withdrawal. If you are withdrawing from an IRA account, you will need to pay state and federal taxes. Keep in mind that if you are withdrawing early, additional penalties will have to be paid as well. By the time you make these payments, you may find yourself with less money than you need to sustain your current lifestyle.

Meanwhile, another factor is spending. Because the 4% rule is a static distribution, it assumes that you’ll spend the same amount of money each year throughout retirement. It does not allow for flexibility in spending. 

Likewise, it does not make any concessions for market returns that vary from historical norms. In a year where markets are low, there’s a chance a 4% withdrawal is actually too much.  

Likewise, a year with better returns than historical returns would mean you could have comfortably withdrawn more than 4%. The problem is that returns are unpredictable, and taking out a fixed amount is not a guarantee that you’ll have funds for the entire 30 years. 

Is the 4% Rule Right for You? 

Personally, I think the 4% rule is best used as a jumping-off point but should not necessarily be followed strictly. Instead, determine how much you should withdraw from your retirement fund based on the exact composition of your portfolio, the return you are getting, and the kind of lifestyle you want in your retirement.  A static withdrawal, like the 4%, simply doesn’t account for the various changes that happen in your life as well as the financial markets.

While figuring out how much to withdraw annually from your retirement account can be overwhelming, it doesn’t have to be. I have several free resources available to help you navigate the retirement planning process. You can find my free retirement planning books at freeretirementbooks.com

If you have specific questions about figuring out how much you should withdraw, feel free to book a call with me at StartMyRetirement.US

If you want you can listen to it on a podcast HERE!