What is the 4% Retirement Rule?

What is the 4% Retirement Rule?

Retiring is a goal that most workers dream of, but the dream of retiring does not often live up to the reality. While many retirees enjoy the influx of free time and not having to make a morning commute, there are several complications with retiring. 

One of the biggest issues facing retirees is a limited income. Once you retire, you’ll likely live on a fixed income.

There are few ways to earn extra income once you retire, but if you carefully budget and plan ahead with your finances, you may be better prepared to comfortably enjoy your retirement years.

Knowing how much you should spend can be tricky, but the majority of financial advisors recommend using the 4% retirement rule. With the 4% retirement rule, you withdraw 4% of your total retirement savings during the first year of retirement. 

Each following year, you adjust how much you withdraw based on any changes to cost of living. If the cost of living increases by 2%, for example, you would then withdraw 6% the following year to account for inflation.

Advantages of the 4% Retirement Rule

While it is not the only method for retirement planning, the 4% retirement rule has proven the test of time, being in use for nearly 100 years as of writing. 

The rule was originally established after studying stock and bond returns over a 50-year period starting in the early 90’s. Even with changes in inflation over the years, the 4% retirement rule remains accurate for many retirees, making it one of the easiest retirement plans to follow.

Not only is the 4% retirement rule simple, but it also provides a way to predict your income. Even in a turbulent economic state, there is rarely a drastic percentage increase to cost of living each year, typically shifting between one or two percent. 

Once you make the initial withdrawal, you can track how much you need for the following years and can pinpoint how long your finances may last.

The simplicity also helps even before you retire. As you get closer to your retirement date, you can compare how much your initial withdrawal will provide and compare that to your current cost of living. 

If you do not believe you are making enough, you have time to make changes to your finances so you are not caught off guard once you are ready to retire. If you find you are ahead of where you want to be financially, you may even be able to cut down on work, or even consider an early retirement.

Finally, the 4% rule is designed to make your savings last. Using the rule, you can often live off of your retirement for at least 30 years, while still having some money in your account to leave behind when you pass or cover any unexpected expenses.

Downsides of the 4% Retirement Rule

While the 4% retirement rule benefits from simplicity, this can also be a potential downside. 

The 4% retirement plan only works If you strictly adhere to the policy, meaning it is not as adaptable as other retirement methods. If you are on a tight retirement plan, you may be at financial risk if there is an emergency that requires you to withdraw from your retirement plan to cover. 

It can also make it difficult to plan if you want to be particularly active during your retirement, such as traveling around the world. While you can try and estimate your travel costs each year, there is a much greater variance depending on where you want to travel.

Planning for the 4% Retirement Rule

In order to make the most of the 4% retirement rule, you still need to adequately prepare your savings. If you only have a few thousand dollars in your retirement account, you may not be able to cover your basic expenses for the first year. 

Figuring out how much you need to stretch out your retirement account can be tricky. 

Financial experts advise basing your total retirement funds based on your life expectancy. While this makes sense on paper, calculating your life expectancy is not an exact science. 

There are various calculators available that provide a rough estimate based on factors such as the following:

  • When you were born
  • Where you were born
  • Family history
  • Current health

A common recommendation is, unless you know you have specific medical conditions, to plan for at least 30 years. 

This covers a significant portion of your post-retirement life, and in the event something happens that causes you to pass early, you still have a generous retirement savings to bequeath to your family and friends.

Investing in your Portfolio

Stocks can be an excellent way to boost the value of your portfolio. The earlier you invest in stocks, the more your investment pays off. 

However, you do not want to make the mistake of only relying on stocks. If there are unfavorable changes in the market, your retirement account can take a significant hit. 

You may also want to add cash and bonds to your account to offer financial stability. Additionally, if your stocks are still growing by the time you are ready to retire, you can continue to let your stocks sit for the first few years while you withdraw your cash and bonds to cover the initial retirement costs.

Variations on the 4% Retirement Rule

As of writing, there are two variations on the 4% retirement rule. The only difference in the variations is how much you initially withdraw. 

Some financial experts recommend decreasing the plan to 3.3%, while others advise increasing the amount to 5%. Despite the name, the plan does offer a small amount of flexibility in how much you initially withdraw. 

Even if you increase the amount to something much higher, like 6 or 7%, the plan can still last for around 30 years.

The 4% retirement rule also allows some flexibility with how much you withdraw in future years. You do not want to drastically increase how much you take out, but you can set aside a small portion of your savings for luxury costs or emergency spending. 

The most important aspect is you keep an eye on your retirement account and make sure you track how much the extra spending will cost in the long run.

By Admin