After decades of saving for retirement, many new retirees often find themselves facing a new challenge: Determining how much money they can take out of their retirement account each year, without running the risk of depleting their nest egg too quickly.
One rule of thumb used by some professionals is “the 4% rule.”
What Is the 4% Retirement Rule?
This “rule” suggests that retirees start by withdrawing 4% from their overall nest egg, and adjust that dollar amount each year based on inflation.
Because the withdrawals would at least partly consist of dividends and interest that continue to accrue, the entire amount withdrawn each year would not totally come out of the principal balance.
This post will explore this rule in more depth, including how it originated, misconceptions some people have about the rule, the potential risks associated with it, and whether it’s still a viable strategy today.
Origination of the 4% Rule
Many people think that the 4% rule ensures that a retiree won’t run out of money in their retirement, but Bengen came up with the 4% in rule in 1994, based on an analysis of investment data going back to 1926. Bengen used this historical data to determine the maximum safe withdrawal amount that a retiree could sustainably take out for each rolling 30-year time frame.
Because this withdrawal percentage reflects what has happened in the past, this may or may not accurately predict what will happen now and in the future.
Also, in 2005, Bergen revisited his calculations and expanded his sample portfolio to include small cap stocks. He found that with this additional asset class, he could increase the annual withdrawal amount, so it is now also referred to as the 4.5% rule.
Common 4% Rule Misconceptions
Many mistakenly believe that Bengen’s rule will ensure that a nest egg last all the way through retirement, but Bengen’s calculations, he was not determining a percentage that would help to ensure that someone’s retirement savings would last a lifetime. Instead, he was calculating what withdrawal level would result in retirement funds lasting a minimum of 30 years.
Another common misconception focuses on how to calculate the 4%, with some people believing that the percentage should be calculated each year at the current principal balance. In Bengen’s formula, it should only be calculated once, based on the principal balance of the retirement funds when the person first retires.
So, if the balance was $500,000 at the point of retirement, then the maximum annual withdrawals would be $20,000. If the starting balance was $1 million, then it would be $40,000, and so forth.
Here are two more things to consider: Bengen used sample portfolios that contained 50% stocks and 50% bonds.
Portfolios with different investments of varying percentages would likely have different results, depending on that portfolio’s risk level.
And, because success in this theory is defined as having money left over after 30 years—meaning, any money whatsoever—Bengen’s definition of success may not align with that of a typical retiree. For example, if, after 30 years, a retiree had $10 left in a retirement fund, then the 4% (or 4.5%) rule would be considered a success. Would a retiree who might live five years longer (or more!), without any more money to withdraw, consider this a successful management of funds?
Risks of the 4% Rule
One challenge associated with this rule, as noted above, is that it only addresses 30 years’ worth of time. So, if someone’s life expectancy goes beyond 30 years post-retirement they could find themselves out of money.
Other challenges can exist for retirees who have chosen investments that have higher risks than average ones. In that case, they may need to take a more conservative withdrawal approach, particularly in the years immediately following their retirement because a market downturn could have a bigger impact on the value of those portfolios.
If retirees take a larger withdrawal, especially early on, this lowers the principal in a way that will affect compound interest throughout retirement years. If this happens, then the retiree can’t simply pick up with the 4% rule from that point on. On the other hand, if a retiree spends much less in a given year, the rule doesn’t adjust for that either.
Is the 4% Rule Too Conservative?
Some financial professionals believe that the 4% rule is too conservative, assuming that the United States doesn’t experience a significant economic depression. Because of that, retirees may be too frugal with their retirement funds and not necessarily live life as fully as they could.
Others say, this rule doesn’t take into account any other sources of income retirees may have, such as Social Security, company pensions, or an inheritance.
So, what’s the right withdrawal strategy to take? It depends. The most appropriate withdrawal strategy for any individual will depend on their unique goals and financial picture.
Starting to Invest for Retirement
It’s never too early to start investing for retirement. This can be challenging for young professionals with other financial goals, including things like paying down student loans or saving up for a house downpayment.
Recommended: How Much Should I Have Saved by 30?
But, starting sooner rather than later can make a huge difference in accumulating savings, perhaps hundreds of thousands of dollars of a difference. And whether you follow the 4% rule or not, the more you have saved for retirement, the more you’ll be able to spend in those years.
To get yourself on track for retirement, consider putting your retirement savings in these accounts:
401(k) or other forms of workplace retirement plans
With a workplace plan, employees typically contribute part of a paycheck, using pre-tax dollars, up to $20,500 per year into their retirement account. Those age 50 and older can contribute an additional $6,500. Companies sometimes offer a “match,” which means that the employee’s contribution gets matched up to a certain percent by the employer. This account is tax deferred, meaning no taxes are paid on the funds until they are withdrawn. However, withdrawing these funds early—generally before age 59 ½,—could trigger an additional 10% early distribution tax.
💡 Recommended: How to Start a 401(k) Plan
SEP IRA, SIMPLE IRA or Solo 401(k)
Traditional IRA (individual retirement account)
This is a tax-deferred retirement account, one that’s not tied to the workplace. So, this is also an option used by freelancers and other self-employed people, as well as people who don’t have 401(k) accounts at work. Contribution limits for an IRA for people under age 50 are capped at $6,000 annually; those who are 50 or older can contribute up to $7,000 each year. This account also has a 10% tax penalty for early withdrawal.
This is another form of retirement account that’s not connected to the workplace, and contribution limits are $6,000 annually. The taxation system for a Roth IRA, however, is different, with income taxes paid in advance on contributed money. But, when retirees withdraw funds, the money is not taxed. Not everyone qualifies for a Roth IRA (there are income limits) but it can be an option for those who are employed by a company as well as those who are self-employed.
Ways to Save for Retirement
If it seems challenging to save for retirement, given your other expenses, a good first step is to create a budget that works for your income and expenses, and includes contributions to a retirement account.
This should be a reasonable budget—meaning that it’s realistic, one that can be adhered to. It makes sense to review this budget regularly, perhaps every few months, and adjust as needed.
In situations where employers offer a 401(k) plan with a contribution match, then it can be a wise move to participate in this program. Matches, remember, are essentially free cash.
Also, consider which expenses you can cut back to make room for higher contributions. Are there online subscriptions or fee-based apps you can cancel? Can you get a better deal on your cell phone plan? Insurance policies?
Can you consolidate your credit cards into a lower-rate personal loan? Once you’ve paid off your credit card balance or personal loan, consider putting the money from those bills into the retirement account?
What about getting a side gig? You can use special skills, such as photography, copyediting, or cooking, to earn extra money that can go toward additional retirement contributions.
At its core, the 4% rule represents a percentage that retirees are able to withdraw from their savings annually and have them last a minimum of 30 years. For example, someone following this rule could withdraw $20,000 a year from a $500,000 retirement account balance.
However, different people have different dreams for retirement. Some want to travel the world, while others want to spend time with family at home. Some may have other financial responsibilities, like helping a grandchild pay for college. What matters most is that each person plans for the retirement they want to experience.
Given those variations, 4% makes more sense as a guideline than as a hard-and-fast rule for retirees. Having as much flexibility as possible in planning for withdrawals, means saving as much as possible first. A starting place for many people is their workplace 401(k), but that’s not the only place you can save for retirement. Those who don’t have access to a workplace retirement account can open an IRA account online or a plan for the self-employed.
You can start an IRA–or a taxable account–by opening an account on the SoFi Invest® investing platform. Use it to build a portfolio including stocks and exchange-traded funds. You can take a hands-on approach with Active Investing, or a hands-off one with Automated Investing. Plus, fractional shares allow you to start fractional share investing. You can select your favorite companies and invest in them, without needing to commit to buying a whole share.
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.