The 4% rule says that you can withdraw 4% of your nest egg in the first year of retirement, and adjust that amount annually for inflation thereafter, without having to worry about exhausting your resources. It assumes the other 96% of your nest egg remains invested in a mix of stocks and bonds.
If you want a simple answer to the title's question, the answer is: Yes, it's a great rule of thumb!
The 4% rule is an important benchmark for those in the middle of the retirement-planning process. But there are caveats to this endorsement, and it's important you understand them.
It's a rule of thumb
Merriam-Webster's definition of "rule of thumb" is worth referencing here:
A general principle regarded as roughly correct but not intended to be scientifically accurate.
This is precisely as the 4% rule should be regarded: roughly correct but not totally accurate.
If we zoom out and look at the average American's preparedness for retirement, we see a population that will struggle mightily to continue living the same lifestyle in retirement. A 2015 report by the Government Accountability Office found that the median household between age 55 and 64 had a nest egg of $104,000. For those between 65 and 74, the figure was $148,000.
That might sound impressive. But it isn't -- and that's where the 4% rule comes in.
Using the rule, we see that $104,000 would provide just over $4,000 per year of income. The higher saved amount for those over 65 would provide just under $6,000. Of course Social Security will chip in, and some people have pensions to count on as well.
But for many of today's workers, pensions are scarce, and there's a real possibility that Social Security benefits could be cut in the future. Knowing that, it's important to understand how big your nest egg needs to be to provide for you in retirement.
As Merriam-Webster reminds us, even if we do a prodigious job saving, we can't blindly follow this rule of thumb as if it's a law. There are certain scenarios where dogmatically following the 4% rule could lead you into trouble.
The first is not including provisions for taxes and/or fees. Let's say you have a $500,000 nest egg and are counting on the $20,000 of income it provides. But you forgot that, since the money is coming from a 401(k) or Traditional IRA, it would be taxed as ordinary income. For a married couple, that will eat up over $2,000 of your income immediately.
Furthermore, if your money is invested with a fund that requires you to pay a fee when you make a withdrawal, you can't count on that cash ever making it into your bank account.
The second major caveat has to do with your investment returns. The first five years of retirement are critical for the sustainability of your nest egg. If the market -- and thus, your nest egg -- suffers big setbacks during this time frame, not only will the money you withdraw disappear forever, but so will the future growth that this money could have produced over the course of your retirement.
If you find yourself in this situation, it'd be worth considering taking out a smaller percentage -- between 2% and 3.5%, depending on how severe the downturn is. Because you've just retired, you're likely still mobile enough to consider getting a part-time job to bridge the gap, or you can adjust your budget to take advantage of newer circumstances that require less income.
Regardless of how the specifics play out in real life, I have no doubt that if every student were introduced to the 4% rule starting in middle school -- and had to revisit it every year thereafter at least once -- many of today's workers would be doing a better job with their retirement planning.