After years of saving for retirement, you may be ready to start withdrawing money from your nest egg. But determining how much to take out each year can be tricky. That’s where the 4% rule comes in.
The 4% rule suggests withdrawing about 4% of your savings each year you’re retired. It’s just a general guideline, though – it’s still important to personalize your approach to account for your situation.
Here’s how the 4% rule in retirement works and why it may be a safe withdrawal rate in your golden years.
What is the 4% rule in retirement?
The 4% rule is an approach to budgeting in retirement. Specifically, it suggests withdrawing 4% of your retirement savings in the first year of retirement. You’ll continue to withdraw about 4% each year after that but can adjust the amount for inflation. ¹
This rule for retirement planning comes from William Bengen, a financial advisor who analyzed data on investment returns over 50 years. Bengen concluded that 4% per year was a safe withdrawal rate that would last most retirees at least 30 years. ²
While the 4% rule is appealing in its simplicity, it’s not the end-all-be-all approach to retirement planning. It makes a lot of assumptions about the makeup of your investment portfolio, for one, and it doesn’t necessarily take the fees and taxes you might pay into account.
Plus, there’s no guarantee that what worked in the past will apply in future years. While the 4% rule is a valuable benchmark, it’s always worth adjusting your approach so that it works for your situation, the same way you should personalize the amount you save for retirement each month.
Mastering retirement planning: how to tackle inflation
The 4% rule for retirement isn’t static — it allows you to adjust for inflation each year. Inflation measures the rate at which goods and services increase each year. It can vary significantly from year to year, but the annual average over the past century was about 3%³.
Let’s say, for example, that you’ve saved $1 million for retirement (note that the average savings by age 65 is lower at $232,710). Using the 4% rule, you’d withdraw $40,000 in your first year of retirement. If the inflation rate went up 3%, you’d increase your withdrawal from $40,000 to $41,200 ($40,000 x 1.03).
Basically, you’d give yourself a small raise each year to account for the price increase and ensure you can live sustainably on your retirement income. If you’re starting early, learn how to plan for retirement in your 20s and 30s.
Pros and cons of the 4% rule for retirement
The 4% rule is a helpful guideline for determining how much you can take out from your savings in retirement without running out of money, but it also has potential downsides. Here are the main pros and cons.
Pro: It’s easy to understand
Retirement planning can be a confusing process, especially once you’re ready to start taking withdrawals from your savings. The 4% rule simplifies the process by providing a straightforward answer to how much to withdraw annually during retirement.
Pro: It contributes to stability
Following the 4% rule, you’ll have a predictable, steady income during retirement. You can easily calculate how much income you’ll have each year while making slight adjustments for inflation.
Pro: It helps you not run out of money
Although there’s no 100% guarantee, your retirement savings should last for at least 30 years if you follow the 4% rule. If you take out a lot more, you run the risk of running out of money during your retirement years.
Con: It doesn’t adapt to changes
The 4% rule assumes you can live on the same income year after year, which may not be realistic for many people. If you run into significant expenses or want a lifestyle change, you may need more income one year than another.
Con: It’s a worst-case scenario projection
When Bengen developed the 4% rule, he based it on historical data that included severe economic downturns, such as the stock market crash of 1929². As a result, this rule may be more conservative than you need and could leave you with a significant amount of money left over. At the same time, predicting the future is impossible, so you may prefer a conservative approach that prioritizes safety over risk-taking.
Con: Higher percentages could work better
Depending on your lifestyle, living on 4% of your retirement savings may amount to a much smaller income than you’re used to. In this case, you would have to make big changes and change your budget to live off this smaller income.
Plus, your portfolio may be balanced differently than the samples that Bengen relied on to develop this rule. You may be averaging an annual return on investment of 9% or more⁴, potentially permitting you to withdraw more than 4% of your savings each year.
4% rule calculation for a safe withdrawal rate
To apply the 4% rule, first, you need to find your retirement savings account totals. That means adding up all your account balances, such as 401(k)s and IRAs, investments, and residual income.
Next, multiply that total by 0.04. That number will represent your total withdrawal for your first year of retirement.
Let’s say that you’ve saved $1.5 million for retirement. Using the 4% rule, you’d withdraw $60,000 in your first year.
In subsequent years, you could increase the amount to account for inflation. Maybe the inflation rate is 2% the following year.
Multiply $60,000 by 1.02% to get $61,200. You could repeat this calculation for future years to continue adjusting your withdrawal amounts.
Stay flexible with your approach to retirement planning
The 4% rule is a straightforward guideline for budgeting in retirement, but it doesn’t consider your unique circumstances. Plus, you can never predict what will happen in the future regarding the economy or changes in your life.
While the 4% rule can be a useful starting point, feel free to adjust your planning to work for you. That way, you can determine an income that’s sustainable for your lifestyle and will last for decades to come.
For more guidance, check out our guide on how much money you need to retire.