| ||||||||||||
The 4 percent withdrawal rule is a popular guideline for retirees, a suggested strategy for converting their savings into a sustainable income stream.
As with most financial formulas, however, it is not a one-size-fits-all solution. To be useful, the 4 percent rule must be tailored to your profile and unique financial goals. And it must be adopted with full awareness of its limitations.
If you plan to apply the 4 percent withdrawal strategy, or even use it as a yardstick to estimate your future retirement income, here’s what you need to know:
- It is not a fixed percentage.
- It does not account for taxes or investment fees.
- You may need to adjust your withdrawals when your RMDs kick in at age 73.
- Your time horizon in retirement (life expectancy) may alter your withdrawal rate.
How much can I safely withdraw? The 4 percent rule explained
Before delving into the details, let’s discuss how the 4 percent rule works.
In essence, the 4 percent withdrawal strategy suggests that retirees may be able to safely siphon off 4 percent of their investment portfolio for living expenses in their first year of retirement, adjusting higher for inflation every year thereafter.
By limiting themselves to an initial 4 percent withdrawal and allowing their remaining investments to continue to grow, their retirement savings should, in theory, last 30 years or more.
An example: If you have a $1 million portfolio, you would withdraw $40,000 during the year you retire ($1,000,000 X .04 = $40,000), and adjust for inflation in subsequent years. If inflation rises 3 percent the following year, your withdrawal would be $41,200 ($40,000 X .03 = $1,200) and so on.
It’s important to note that the 4 percent rule applies only to your investment portfolio. It does not include your guaranteed sources of income, including Social Security, pensions, and any annuities you may have. Those sources will supplement your investment withdrawals.
“The 4 percent rule can potentially be sustainable, especially today with high-yield savings accounts paying close to 5 percent,” said Lisa Frankovich, a financial professional with GoldBook Financial in La Jolla, California. “But we have a lot of pressures going forward in terms of what the stock market is going to look like. Careful financial planning can help ensure that you’ll have enough money to sustain you.”
Limitations
Like all financial rules of thumb, the 4 percent formula is a blunt instrument, meant primarily for back of the envelope math.
Applied blindly and without a personalized plan, it could encourage overspending, causing you to drain your savings prematurely. Or, it may artificially restrict how much you can safely spend, which leaves your heirs with a bigger inheritance but denies you the chance to check off some bucket list experiences during retirement. (Learn more: A closer look at 6 financial rules of thumb)
Ultimately the withdrawal rate that is right for you will depend on your:
- Account balance.
- Age at retirement.
- Investment returns.
- Living expenses.
- Estate planning goals.
- Guaranteed income.
For example, if you don’t plan to leave a financial legacy behind and you can cover your living expenses with Social Security and other sources of guaranteed income, you can potentially afford to spend your retirement savings more freely.
Your projected health care costs may also affect how much you can safely withdraw, said Frankovich. Those who transfer risk with long-term care insurance coverage, for example, may potentially be able to draw down their portfolio more aggressively than those who don’t. Frankovich said some of her clients plan to privately fund any nursing home costs they may incur by reinvesting their required minimum distributions (RMDs) when they turn age 73.
“The use of permanent life insurance could also potentially offset the need to set aside additional assets for future health care costs and thus may allow for greater distributions in retirement,” said Daniel Drabinski, founder and chief executive of Integrated Strategies in Dallas, Texas, noting some hybrid life insurance policies offer long-term care benefits in addition to life insurance coverage. (Learn more: How life insurance can help supplement retirement income)
A financial professional can help you create a sustainable withdrawal rate based on your unique profile and financial objectives. They may also encourage you to consider alternative withdrawal strategies that might help you reach your goals faster. More on alternative strategies below. (Learn more: The ideal retirement withdrawal rate)
It’s not a fixed percentage
Those applying the 4 percent rule in retirement should understand that it is not a fixed percentage. It is merely a suggested starting point with inflation adjustments baked in.
Without adjusting for cost-of-living increases, retirees who could comfortably live on monthly withdrawals of, say, $3,000, in their first year of retirement, might struggle to make ends meet 20 years later when the cost of goods and services has climbed — even those with a paid-off home. (Related: Pay off the mortgage before you retire?)
It is also important to understand that while the 4 percent rule may be based on an initial fixed withdrawal rate, the value of your portfolio will change year-to-year based on market performance. Thus, the amount of income you receive is subject to change.
If your portfolio balance jumps by 10 percent one year, your investment income using the 4 percent rule will be higher. And, if you encounter a bear market that reduces your account value the following year, your 4 percent (plus inflation) withdrawal may be too little to live on.
Some financial professionals urge retirees to maintain an oversized cash cushion of at least one to two years from which to draw during periods of stock market decline, giving their investment portfolios time to recover. That’s especially prudent in the early years of retirement when dipping into a depressed portfolio would have a disproportionately negative impact on your long-term financial security. (Learn more: Beware retirement’s overlooked risk: Sequence of returns)
The 4 percent rule does not account for taxes or fees
Another important reminder is that the 4 percent withdrawal rule does not account for taxes or investment fees, which can significantly erode your spending power during retirement.
If the bulk of your withdrawals are coming from pre-tax accounts, including a 401(k) or a traditional IRA, you will owe ordinary income tax on those distributions. Withdrawals from Roth IRAs, however, which are funded with after-tax contributions, are generally tax free depending on qualifying conditions and your age.
It is important to understand the different tax treatment of retirement accounts. A financial professional can help you implement a tax-efficient withdrawal strategy that may make your savings last longer.
Note that some retirees are in a lower tax bracket during retirement. But if your nest egg is sizeable, you could potentially find yourself in a higher tax bracket, especially after RMDs kick in at age 73. (Learn more: Turning 73? Required minimum distributions explained)
Investment fees also reduce your real returns, which may necessitate a higher withdrawal rate and could increase the risk of outliving your assets.
In the same way that investment returns compound over time, the effect of fees on your portfolio compounds over time. The higher your fees, the less money you have to invest, and the lower your net returns tend to be. It is important to understand the fees you pay so you can maximize your future retirement income.
How do RMDs affect the 4 percent rule?
Retirees who adhere to the inflation-adjusted 4 percent rule often get confused about the implications of RMDs on their withdrawals, understandably so.
When retirees turn age 73, they must begin taking RMDs from their pre-tax accounts, such as their 401(k) and traditional IRA.
Those RMDs may exceed 4 percent of their pre-tax account value, but still represent less than 4 percent of their total portfolio. If they restrict themselves to only spending their RMD, in that case, their withdrawal rate would be too conservative.
Conversely, if their pre-tax savings are significant enough, their RMDs may exceed 4 percent of their total portfolio, especially as they age and their RMDs increase. To bring their withdrawal rate back in line, they may need to restore balance by reinvesting the excess in a taxable brokerage account.
“It’s important to work with a competent team, including both a financial professional and an accountant who understands RMDs and can help you avoid potential penalties,” said Drabinski, noting that the RMD rules for both personally-held and inherited IRAs have changed per the Secure Act 2.0. “Those rules should ultimately supersede any specific withdrawal needs, but should also help guide your decisions in conjunction with understanding your lifestyle needs.”
In some cases, he said, distributions from annuities in qualified accounts will cover RMD requirements and eliminate the need to take additional distributions from an IRA.
“However, if the IRA is inherited, you may have a separate set of rules to distribute those assets over the course of 10 years, so it’s important to look at the full picture of everything you own and determine the most appropriate assets to distribute,” said Drabinski.
Your withdrawal rate may change as you age
Regardless of how your RMDs align with your total investment portfolio, your age will affect your withdrawal rate.
Remember, the 4 percent rule is based on a 30-year retirement time horizon.
If you retire early, your life expectancy is longer and you may therefore have to reduce your withdrawals to account for the additional years you may spend in retirement.
On the other hand, as you age, your life expectancy decreases, which may allow for a gradually higher withdrawal rate. At age 80, for example, you no longer need your savings to support you for 30 more years, so it may be possible to increase the amount of your withdrawal.
It is important to revisit your withdrawal rate throughout your retirement journey.
Alternatives to the 4 percent rule
The 4 percent rule was popularized in the 1990s, based on historical market data. It assumed that retirees maintain an asset allocation of 60 percent stocks and 40 percent bonds, and it did not factor in guaranteed income from pensions or annuities. The formula reflects what was viewed at the time as having a high probability of success in a worst-case scenario.
But market pressures have changed, and some suggest that the proposed 4 percent rate may now be too aggressive. Others argue that some retirees can safely afford to withdraw more.
“In reality, every portfolio is different and every client situation and need is different,” said Drabinski. “Mathematically, rising volatility in the equity markets has skewed potential distribution rates lower, while the addition of fixed rate products and consistent income streams — via pensions and annuities — has counter-balanced that rate.”
Alternative withdrawal strategies to consider include the:
- Percentage-of-portfolio strategy, also called the “dynamic strategy,” in which you spend a fixed percentage of your portfolio every year and adjust based on your investment returns. When your portfolio performs poorly, you would spend less. This strategy may not be right for you if you rely on consistent income to pay the bills.
- Fixed-dollar strategy, in which you withdraw the same dollar amount from your retirement portfolio every year. This makes it easier to implement. But it may also increase inflation risk and you may deplete your savings faster than expected if your portfolio returns remain depressed for consecutive years.
- Income floor strategy, in which retirees divide their expenses into wants and needs. They first develop a plan to cover their essential living expenses with guaranteed sources of income from Social Security, pensions, and annuities. Their non-essential, or variable expenses, would then be covered by systematic withdrawals from their investment portfolio, enabling them to dial back on spending during bear markets and give their account balance time to recover. This plan can potentially limit retirement income growth (if building the income floor requires too much of their portfolio to be allocated to conservative investments.) It may also offer less flexibility if financial circumstances change.
“Generally speaking, your withdrawal rate should fluctuate with your lifestyle and anticipated heath care needs,” said Drabinski. “We typically advise clients to annuitize their fixed expenses first, which means identifying your hard expenses and ensuring they are covered with what I call ‘pension income’. That can come from an income-producing asset like a dividend, annuity, or rental income. But it should be relatively fixed and reliable.”
Once your fixed expenses are covered, he said, you can focus on the next layer of income-producing assets, which may be slightly more volatile.
“Only after your liabilities are covered should you fully focus on purely growth or speculative assets, and the distribution rates you take from those assets are largely based upon your lifestyle needs and your long-term goals for passing down assets,” said Drabinski.
Conclusion
In the pantheon of personal finance rules of thumb, the 4 percent withdrawal rule is often referenced and widely adopted. As a starting point to create a sustainable retirement income stream, it has utility.
To ensure you don’t outlive your savings or unnecessarily live below your means, however, your withdrawal rate must be tailored to your objectives.
A financial professional can help you determine how much you may be able to safely spend based on your life expectancy, financial goals, lifestyle, investment returns, and income needs.
Discover more from MassMutual…
5 tips on how to reduce taxes in retirement
Protecting retirement savings from market volatility
Need a financial professional? Find one here
________________________________________
