Planning for the future is difficult, especially when it comes to your retirement finances. What will things cost in the future? How much can I spend? Will my funds last? All of these questions are make planning for retirement seem daunting. However, these questions actually help a lot in preparing yourself for retirement! The answers to these questions assist in calculating what dollar amount you should have by retirement age. In this article, I’ll be going over the 4% Rule which is a general rule of thumb to help approximate how much money you will need to retire. The 4% rule uses the answers to our retirement questions to help calculate how much we will need to retire.
What is the 4% Rule?
The 4% Rule is a retirement guideline for the amount you should withdraw from your retirement accounts without needing to touch the principle.
The creation of this rule tried to account for the safest possible withdrawal rate that won’t deplete your funds over time. What the 4% rule takes into account is that the general stock market sees an average return of 8%. So, to make a long story short, by withdrawing only 4% of your funds won’t deplete them as they will be replenished by the expected 8% return.
Here’s an article showing the average return over different 30 year periods: Average Returns
How Much to Retire?
The math to calculate how much you need to retire is actually quite simple. It is (Amount in Retirement Funds) X (4% annual withdrawal) = Annual withdrawal.
For instance, let’s say your annual living expenses were $30,000. Then the equation would look like this: (Amount in Retirement Funds) X 4% = 30,000. Using some algebra we get $750,000 as the amount you need to retire.
That large amount of principle may seem crazy but that’s why it is important to start saving early! Here’s our article on ROTH IRA’s to help get you started
The Cons to the 4% Rule
In today’s modern age, the 4% Rule is more of a guideline rather than an actual rule. Although it is simple and easy to use, the rule makes some assumptions or doesn’t account for certain factors that make it fall apart.
Cons:
- The Rule doesn’t account for inflation or market downturns. Nowadays, each year there is roughly 2% inflation which subtracts from your annual return. So an average 8% return is now really 6%. During a bad stretch of returns your effective rate could be negative.
- The Rule only accounts for living expenses. The 4% withdrawal rate is only meant to cover your yearly living expenses. Meaning food, utilities, insurance, rent, property tax, etc… So, doing more lavish things like buying sports cars every year will require more money to retire.
- The Rule doesn’t account for you continuing to work. Many people may retire from their career job but will continue to work but maybe less. This factor would increase the longevity of retirement funds but the Rule does not account for this.
Overall, the 4% rule is a good place to start in planning your retirement. It immediately gives you a basic retirement plan and amount you need to achieve that plan. However, the 4% rule is by no means the perfect retirement plan that everyone should follow to the letter. Everyone is different with different situations and those factors should be included in planning for retirement. Lastly, there are plenty of resources to get a better idea of how to retire online, hopefully this article got you started… Happy investing!
The Common Trader 