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How the 4% Retirement Rule Works

September 28, 2020 · 7 minute read

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How the 4% Retirement Rule Works

As people prepare for their retirement years, many put away money. And, for those who do, when they retire, the question may be how much can be safely taken out each year without depleting funds for the years yet to come.

Financial professionals often give their clients recommendations about that topic, and the 4% rule is an example of what one expert determined to be an historically safe annual withdrawal amount. “Safe” in this context means that, by withdrawing that amount, retirees would have a flow of monthly income while still preserving some of the principal balance of their retirement funds.

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the withdrawals would at least partly consist of dividends and interest that continue to accrue, the entire amount withdrawn each year would not totally come out of the principal balance.

So, when deciding what to withdraw annually, is this rule still considered accurate, or at least useful for a reasonable number of people?

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—along with strategies to build up balances in retirement accounts.

Origination of the 4% Rule

William “Bill” Bengen conducted a study and published his results in 1994. From this study came the 4% rule.

Bengen took investment data that began in 1926. He then used this historical data to determine the maximum initial withdrawal amount that could sustainably be taken out for each rolling 30-year time frame. In each data set, he calculated the worst and best scenarios that could occur.

Out of these true-to-life scenarios, he determined that the 30-year period beginning in May 1965 was a worst-case scenario, one where a $1 million portfolio could only have a $40,700 initial withdrawal.

Contrast that with the best scenario, which began in August 1982—and which had an initial withdrawal of $112,900 from the same size portfolio—and you can see the range of his results based on time frames.

Because this withdrawal percentage is based on what has happened in the past, this may or may not accurately predict what will happen now and in the future. Sometimes the rule is being referred to as the 4.5% rule.

Common 4% Rule Misconceptions

In Bengen’s calculations, he was not determining a percentage that would help to ensure that someone’s retirement savings would last a lifetime, no matter how many years they lived, post-retirement. Instead, he was calculating what withdrawal level would cause retirement funds to last for 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. Instead, it should only be calculated one time, based upon 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 and percentages of them would likely have different results, depending upon the levels of risk inherent in those portfolios.

And, because success was defined as having money left over after 30 years—meaning, any money whatsoever—Bengen’s definition of success may not match that of a 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 under these parameters.

Would a retiree who might live five years longer (or more!) without any more money to withdraw consider this successful management of the 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 it could pose financial challenges.

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 hit these portfolios harder than what’s typical.

Plus, when 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.

Is the 4% Rule Too Conservative?

Some financial professionals believe that the 4% rule is actually too conservative, as long as 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.

Plus, some say, this rule doesn’t take into account any other sources of income retirees may have to rely upon, such as Social Security or company pensions.

So, what’s the right withdrawal strategy to take? What’s important is to create a retirement savings plan that takes into account the unique goals of the person, and to focus on building up a significant enough account, balance-wise, to help retirees live their lifestyles of choice.

Here are strategies to consider.

Starting to Invest for Retirement

When considering the best time to start investing for retirement, just about every financial advisor would say to start right now. This can be challenging if, say, someone is trying to pay down student loans or save up for a down payment for a house.

But, starting sooner rather than later can make a huge difference in accumulating savings, perhaps hundreds of thousands of dollars of a difference.

It can also help to understand the different types of retirement accounts available; who they’re available to; and their tax consequences. (Note: This is not tax advice, and you should consult with a tax advisor regarding taxing on retirement plans.) Retirement fund types include:

•  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 $19,000 per year into their retirement account. Companies sometimes offer a “match,” which means that the employee’s contribution gets matched up to a certain percent by the employer. The match is more or less free money. This account is tax deferred, meaning no taxes are paid on the funds until they are withdrawn. Withdrawing these funds early, though, could trigger a 10% penalty along with the income tax consequences.

•  SEP IRA or Solo 401(k): These are retirement fund options for people who are self-employed.

•  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 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 penalty for early withdrawal.

•  Roth IRA: 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 on contributed money. In other words, this is not a tax deferred account like a traditional IRA is. But, when retirees withdraw funds, the money is not taxed. Not everyone qualifies for a Roth (there are income limits) but it can be open to people 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, here are a few tips.

A good first step is to create a budget that works for the person’s 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) program and then match contributions, then it can be a wise move to participate in this program. Matches, remember, are essentially free cash.

What expenses can be cut back to make room for higher contributions? Are there online subscriptions or fee-based apps that can be canceled? Are better prices available for cell phone plans? Insurance policies?

Can credit cards be consolidated into a lower-rate personal loan? Once a credit card bill or personal loan is paid off, what about putting the money that was being put towards payments into the retirement account?

What about getting a side gig? People with special skills, such as photography, copyediting, cooking, and more can earn extra money outside of their main jobs, and these funds can go towards retirement contributions.

On Track with Retirement?

At a high level, the 4% rule states a percentage that retirees are said to be able to withdraw annually and still have the funds last for 30 years. For example, someone could withdraw $20,000 a year with a $500,000 retirement fund balance.

But, here’s a question that the rule doesn’t address. Is $20,000 enough for someone to live the desired lifestyle during retirement years? Is $40,000 enough? $60,000? What is the right amount?

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 potentially helping a grandchild pay for college. What matters most is that each person plans for the retirement they expect and/or want to experience.

What about having a 401(k) and an IRA? Is that possible? If it’s possible, does it make sense?

Well, for people who have retirement plans through work that include matching funds, it can often make the most sense to take as much advantage of that matching benefit as possible. And, once the 401(k) is maxed out, if more funds are available, it may make sense to contribute to a traditional IRA.

Here’s something else to consider. Once investors reach their annual limits for retirement contributions, that doesn’t mean they need to stop investing money to enjoy during their retirement years.

This can happen through using brokerage accounts for retirement planning. Although they won’t have the same tax advantages as, say, a traditional IRA, this does allow people to keep investing and building wealth.

SoFi Invest

If you’re looking to invest, SoFi Invest® provides opportunities to invest in exchange traded funds (EFTs)—mutual funds that offer a diversified portfolio with no trading fees.

You can take a hands-on approach with Active Investing, or a hands-off one with Automated Investing. Plus, Stock Bits allows 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.

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SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three 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.

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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.
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