Look at most any magazine or news story related to your money and retirement, and you are going to see outrageously high numbers for what your nest egg should look like. And there is value in knowing that you need to save for retirement, but if the goal is not attainable some people might give up and not save anything for retirement. The real number you should be focusing on is the 4% rule.
What is the 4% rule? It’s a number that was determined to allow you to retire comfortably and not have to worry about money in your retirement.
In this post, we are going to look at this number in more detail to see why it works great and what could be a stumbling block. Of course, we will see how you can overcome this as well.
What Is The 4% Rule?
At its most basic, the 4% rule states that you can safely withdraw 4% of the value of your portfolio in any given year and not run out of money in retirement. This number was used in various Monte Carlo simulations to prove that your nest egg will survive during your retirement.
Another way to look at the 4% rule is to simply take your expected annual retirement budget and multiply this amount by 25. When you do this, you have a good idea of what your nest egg size should be at retirement.
For example, let’s say you expect your retirement budget to be $30,000 annually. If you multiply this by 25, you end up with a nest egg of $750,000.
If we use this amount and withdraw 4% annually, you are living on $30,000. See how that works?
The Benefits Of The 4% Rule
The best part about this rule is that it simplifies things. You know you can count on 4% of your money and not run out.
How is this possible?
Since you will most likely be earning more than 4% on your invested money, your portfolio should continue to grow or at least hold steady during your golden years.
And by using 4%, which is just higher than the historical average for inflation, you ensure that as the cost of living increases, you won’t be getting squeezed.
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The Downside To The 4% Rule
Of course, there is a downside to the rule too. Sadly, it is not something you can control. The downside is that you cannot know what the market will be doing when you retire.
This is especially true during the first few years of your retirement. If the market takes a big dive, you are withdrawing 4% of a much lower number and if the 4% is not enough to live on, you may need to withdraw additional funds. This means that you run the risk of running out of money during retirement since you are now using a much larger chunk of your nest egg.
Second, it doesn’t take into account a long term period of flat returns for the market. If the market is only returning 2% a year for 5 years, you are going to be dipping into principal when you take money out.
This means when the market does pick back up, you will have less money that will compound upon itself.
Using The 4% To Your Advantage
So what is the answer when it comes to the 4% rule? The answer is that it is a great way to estimate how much money you can safely withdraw annually during retirement.
But you have to be smart about it. If you estimate you need $30,000 annually and come November realize you have only spent $15,000 you don’t need to keep taking out 4%. See if you can live on less the following year.
Additionally, if you were planning any large expenses, try to put them off for a couple of years after you retire. I am not suggesting you live like a miser during retirement, but the critical factor in making sure the 4% rule works is the market as a whole.
By holding off for a couple years on large expenses, you only increase your odds of having enough money for retirement.
The bottom line when it comes to the 4% rule is to use it to help you determine how much you can safely withdraw each year while retired, and then assess what is actually happening and adjust accordingly.
If you can do this, you only increase the odds of having enough money to not only retire but to also enjoy retirement to its fullest.