Anyone who’s read an article about retirement lately has likely encountered mention of the 4 percent rule. But what is it, exactly? And does it work? We’ve compiled answers to some of your most important questions.
Where did it come from?
The 4 percent rule came out of a 1994 study by financial planner William Bengen. Using historical rates of return, Bengen tested several different withdrawal rates and found that 4 percent was the highest rate that could be sustained over a period of at least 30 years. As such, many planners now suggest a 4 percent withdrawal rate as a good rule of thumb for most retirees.
How does it work?
You withdraw 4 percent of your nest egg—meaning 4 percent of all your investments earmarked for retirement. That’s how much money you have to spend for the next year. In subsequent years, you increase the dollar amount of that first withdrawal just enough to keep up with inflation.
For example, you might withdraw $20,000, or 4 percent of a $500,000 nest egg, the first year. The next year, if annual inflation is running at 2 percent, you’d increase your withdrawal to $20,400, or $20,000 plus 2 percent.
A few things to keep in mind: Dividends, interest, or other distributions paid to you in cash count as part of the 4 percent. And once you reach age 70 ½, you’re required to satisfy the IRS’s minimum withdrawal requirement for 401(k)s and other retirement plans—even if it means breaking the 4 percent rule. Not meeting minimum withdrawal requirements can lead to hefty tax penalties.
Is the 4 percent rule right for me?
The 4 percent rule isn’t perfect, and it may not be for everyone. Retirees should remember that just because the 4 percent rule worked in the past, there’s no guarantee it’s the best approach for the future. Low yields could mean a lower withdrawal rate—say, 3 percent—is more realistic. On the other hand, strong market performance over the long term could allow retirees to withdraw more.
Ideal withdrawal rates will also vary based on any number of variables and unpredictable factors. How long do you expect to live? Will you work past your 60s or retire early? Do you also have pension income? What if you experience a sudden windfall or loss? What about health care expenses?
Most experts, then, suggest starting with a low withdrawal rate—3 percent or 4 percent, typically—and then adjusting as needed, depending on market conditions and your unique circumstances.