Has planning for your retirement ever filled you with a deep and unrelenting sense of dread? I feel you. Working for the future can be challenging, especially when you don’t know how long your investments will keep you afloat after retirement.
However, there is one way to help you with planning ahead. You can use the 4% rule to see how much you can safely take from your account on a yearly basis.
The 4% rule is a common tool used to estimate how much a retiree should withdraw from a retirement account each year. This is to provide a steady stream of income to the retiree each year while also maintaining an account balance that keeps income flowing through retirement.
But you do need to understand it thoroughly, as it is very misunderstood.
Why 4%?
This rule is the result of 50 years’ worth of historical data that was analyzed by financial advisor William Bengen. He analyzed the returns, with an extra focus on the market during the 1930s and 1970s. Bengen eventually concluded that, even in unstable markets, a retirement portfolio with an annual withdrawal rate of 4% would last at least 33 years.Read the full study.
It’s generally thought that the 4% rule is a slightly conservative measurement because it was developed after analyzing the worst economic situations, such as in 1929.
This rule helps retirees and financial planners calculate how much a portfolio’s withdrawal rate should be. Apart from this rule, life expectancy is also taken into consideration because retirees who live longer will need their portfolios to last longer. Medical costs and other expenses could also increase as retirees age.
How It Works
Okay, so the rule says 4%. All I need to do is withdraw 4% of my retirement savings and I’ll be good, right?Wrong. You also need to take inflation into account.
Let’s say you’ve managed to come up with €1 million and inflation is running at 2%. You can start off by withdrawing €40,000, or 4% of what you’ve saved. The next year, you factor in the additional 2% by withdrawing €40,800. On your third year, you take out €41,600.
Why do you need to do this? It’s to maintain your purchasing power as the years go by so you can still afford the same things that you could in the first year.
Misconceptions of the 4% rule
Firstly: the 4 percent rule does NOT guarantee that you'r capital will increase. In the scenarios done in the study, capital had increased with 4% withdrawal rate over 30 year investing periods, but not necessarily shorter.You've heard the 25x -rule too, right? According to this, if you calculate your expenses (say 40,000 € annually), then if you multiply that by 25, you arrive at your required capital to retire - 1,000,000 €. Similarly, you might think that you're withdrawing now 4% from your principal.
You actually need to withdraw more. You are likely not accounting for any capital gains taxes.
Assume you have that one million and your expenses are 40,000 €. Since your capital is invested, you are receiving gains (hopefully). When you sell for profit, you need to pay taxes for that profit.
In Finland for example, if you're a private investor, you pay taxes on dividends and interest immediately - 30%. The same on selling stocks. Since you needed 40,000 € net, the gross can be as high as 57,000 €, depending on your case, but depends on the profit you made during the year.
Of course if you didn't make any profit, the 40,000 € will suffice, but that strategy lasts for 20 only years with 2% inflation. So you need profits. And you will need to account for capital gains taxes.
Do your own calculations
The 4% Rule is highly disputed. It’s not a hard and fast rule for retirement planning. Remember that this is just a general rule for your retirement plan and that it should not be the only reason behind your decisions.This Rule works only for retirees who follow a specific portfolio mix. If a retiree has put their money in higher-risk investments, they will need to be more conservative with withdrawing their money. Also, the rule assumes you make completely automatic, pre-determined actions and do not let your emotions guide your decisions. Most people can't do that in the long term.
Ultimately, the 4% Rule only determines how much you can withdraw from your retirement account, but it does not equal to your expenses. You need to account for taxes, too. You should also be ready to adjust your withdrawals as you go through retirement so that you can adapt to the market as it grows and shrinks. Perhaps even be ready to go back to work if the market turns bad soon after you retire.
