If you have a 401(K) or an IRA fund, you can see the benefit of having some funds just out of earshot that you can access as soon as you reach your golden years.
However, there might be a scenario where you don’t have as much as you’d like, and if you’re receiving retirement benefits, you could see yourself having 50-85% of your income taxed, and it applies more if you have a combined income with a spouse, for example.
The 4 percent rule in retirement may be the option you need.
So is there really a way that you can get an annual income that is a steady stream while having an adequate fund balance for the future?
This is where the 4 percent rule in retirement comes into the equation, and below, we explain what it is and the benefits and drawbacks of using this system.
The 4 Percent Rule In Retirement, Explained
However much you have in a retirement fund, this rule allows you to remove that percent from your fund in the first year and remove the same amount each year after, adjusting for inflation with each successive tax year.
Some may use a 3 or 5% method instead to reduce or increase the risk slightly, respectively, and people may want to avoid any risk that may come from changing interest rates.
The life expectancy of an individual plays a big part in the success of this rule.
The origins of this rule come from stock market analysis over a fifty-year period. Financial institutions may still use this rule when giving financial advice to those who aren’t quite sure what to do with their funds and may want a dividend payout type system.
Why Should I Use This Rule?
This rule has been made to give retirees more security, and this means even during the worst economic scenarios relating to markets, interest rates, or even inflation, as many have said, it is a modest and long-lasting fund that is intended to see you through your later years.
You might also get a situation where you have the option to take out a lump sum, and this can be even more devalued by inflation, and as company plans which offer a 401(K) don’t allow for a cost-of-living adjustment, being able to take an annuity can be beneficial to you here.
If you have a diverse retirement plan that includes stocks and bonds, the applicability of the rule makes more sense as you have a mixture of cash and stock options, and you can adjust your withdrawal to suit the state the stock or bond is in.
However, this may not be the case for everyone.
Some people may feel uncomfortable with leaving half of their funds assigned as common stocks or intermediate-term treasury bonds, as they may want to limit their exposure to the markets as much as possible.
Problems Of Using This Rule
One of the biggest problems of this system is that to keep up with inflation, a retiree can take out an additional 2%.
But this won’t guarantee that the fund will last for the remainder of your life, as conditions could even devalue your fund.
If you have a significant amount of your fund in stocks, this could erode the amount, which is why it is recommended you diversify your portfolio.
Another issue we see is that you have to commit to only taking out a certain amount for this rule to work.
Still, there might be times when you want to spend a bit more on a luxury, which can impact your compound interest and allows the fund to be sustainable.
The viability of the 4% is also impacted if any unexpected expenses appear, such as medical bills.
As this can be difficult to predict, the cost of this can’t really be factored in, as some expenses are going to be costlier than others.
Is The 4 Percent Rule In Retirement Still Valid?
As this rule is based on an older system of analysis, you might be thinking about whether this rule is still worth it or not.
While interest rates are currently at a historic low, you should be mindful of the low yields that come from fixed incomes or investments.
However, some may choose a 5 or 6% withdrawal rate to have a bit more freedom while still having enough compound interest for the withdrawal to be worth it in the first place, as, of course, the less money you have, the less interest that can be accrued on it.
You might also decide to retire early or work past the retirement age; your long-term financial needs will differ, as you may not need an income to last you for the 30 years that the 4% covers you.
Let’s say you have retirement savings of $500,000 and, with the rule, withdraw $20,000 for the year.
For the second year, we could assume inflation is at 2.5% for the first year, so to match it, your withdrawal for the second year is likely $20,500.
In the third year, assuming the same inflation rate, your withdrawal could rise to $21,013, which is possible regardless of the value of any investments or market conditions.
As a baseline, this is a pretty good place to start.
So you can see that the 4% rule has its uses and drawbacks, but what it can do is give you a good income stream that can last the rest of your life, but as we have seen, it isn’t a guaranteed method, and it doesn’t account for any long-term expenses.
The best thing to do is to consult with a financial advisor or planner who can look at your fund and give it a fair assessment of how you could proceed with any withdrawals.