As you build your retirement savings, it is important to consider the impacts of a safe withdrawal rate on your plans. Many experts recommend that you stick to the 4% rule.
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We will take a closer look at exactly what the 4% rule is and what it means for your retirement goals.
How much do I need to retire?
When you consider how much you need to save before retirement, the answer will vary largely based on your spending needs. No matter your spending needs, you can take advantage of the 4% rule to estimate the necessary size of your nest egg.
As you are considering your retirement savings, think about the lifestyle you want to live in retirement. As yourself questions about what you want your future to look like. Where do you want to live? Do you want to travel? What hobbies will you spend your time on in retirement?
The answers to these questions will illuminate what your annual expenses may look like in retirement. For example, let’s say that you want to travel the world on luxurious vacations several times a year throughout retirement. You would require more retirement savings than someone that plans to spend their golden years volunteering at a nearby non-profit.
What is the 4% rule?
After you have a better idea of your annual expenses for your retirement years, you can use the 4% rule to estimate how much you’ll need to save.
The 4% rule is based on a study done by researchers at Trinity University. According to the rule, you can withdraw up to 4% of your portfolio value each year in retirement. If you only withdraw 4% each year, then you should not run out of money in retirement.
What does this mean for my retirement income?
When you base your retirement strategy on the 4% rule, your retirement income will likely fluctuate each year. It is highly unlikely that you’ll withdraw the same amount of funds each year if you are sticking to the 4% rule. That is because your investment portfolio’s value will likely fluctuate.
In years when your portfolio is not performing well, you will not be able to take out as much cash. On the flip side, you may encounter some years that allow you to take out more funds in cash due to an increase in your portfolio's value.
For example, let’s say that you retire with a portfolio value of $1,000,000. In the first year, you will be able to withdraw $40,000 to fund your living expenses. If the portfolio value drops to $950,000 in the second year, then you will only be able to withdraw $38,000 to satisfy the 4% rule. If the portfolio value increases in the third year to $1,050,000, then you could withdraw $42,000.
With a fluctuating retirement income, you may have to make adjustments to your spending based on the market.
How long will my retirement savings last?
The keyword here is that you should be able to withdraw 4% of your investment portfolio each year. However, there is always the slim possibility that you could be an outlier that depletes your retirement savings. With that, it is important to consider the risks of the 4% rule as you create a retirement plan.
In the Trinity study, the time horizon studied was 30 years. With that, the researchers suggested it is likely that you can sustain a 30-year retirement if you abide by the 4% rule. Of course, these suggestions are based on past performance, not a guarantee for the future. But it is likely that the 4% rule will allow you to stretch out your savings over the course of a long retirement.
You can adjust your withdrawal rate up and down to account for your risk tolerance. You could decrease your withdrawal rate to extend the lifetime of your portfolio. Or you could increase the withdrawal rate if you are comfortable with more risk.
In addition to the withdrawal rate, you should focus on creating a balanced portfolio that will allow you to weather the ups and downs of the market. If you are concerned about a bad year squeezing your retirement plans too tightly, then consider creating an emergency fund to cushion any bumps along the way.
How to use the 4% rule
You can use your expected annual expenses and multiply it by 25 to determine how much you should save. For example, let’s say that you intend to spend $40,000 in retirement. With that, you can multiply $40,000 by 25 to arrive at $1,000,000.
In this example, you would need to build a $1,000,000 investment portfolio to abide by the 4% rule and fund your lifestyle.
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The bottom line
The 4% rule is a good rule of thumb. You should use the rule as a guide to help you determine your savings goals for retirement. But you should consider your personal tolerances before using this rule as a benchmark for your retirement savings. Don’t be afraid to adjust the percentage to suit your long-term goals.
As you work to build your retirement savings, take some time to create a strong financial foundation. With a solid foundation, you can make big strides towards your retirement savings goals.