After spending decades saving and investing for retirement, some people may wonder if they've done enough to be financially comfortable through those years. On one end, if you spend too much in retirement, you can find yourself in financial trouble. But, on the other end, if you spend too little, you could shortchange yourself on various experiences that you could be having in retirement. This is where the 4% rule of thumb may be beneficial.
Using the 4% rule
One thing you want to account for when figuring out your retirement finances is ensuring you're in a position to not outlive your savings, and that's when the 4% rule comes into play. The 4% rule says retirees should plan to withdraw 4% of their retirement savings every year for 30 years without worrying about outliving their savings.
Before using the 4% rule, it's helpful to incorporate the "80% rule," which states you should aim to have 80% of your pre-retirement annual income to maintain your current lifestyle in retirement. Of course, this will vary by person because every person has different lifestyle needs, and some may not have a desire to keep their current lifestyle, but in general, this is a good rule of thumb to have as a baseline.
To calculate your ideal retirement savings based on the 4% rule, multiply 25 by your yearly income required in retirement. So, if your preretirement income is $100,000 -- meaning you'll likely need around $80,000 annually in retirement if you follow the 80% rule -- you would ideally have $80,000 times 25 or $2 million saved up for retirement.
When using the 4% rule, it's also important to consider inflation when putting the rule into place. Ideally, you withdraw 4% in your first year, and then in subsequent years, you'll adjust your withdrawal amount based on inflation for the current year. So, if you managed to save $2 million for retirement, in your first year, you'd withdraw $80,000. If inflation rose by 3% the following year, you'd ideally withdraw $82,400.
Utilize the various retirement accounts
One of the best things you can do when saving for retirement is to take advantage of the various retirement accounts available to you, whether it's a 401(k) plan, Roth IRA, or traditional IRA. Once you've used the 4% rule to benchmark how much you should ideally have saved, your next steps should be to put a saving and investing plan into place.
A 401(k) is the primary retirement account for many people, but even that alone may not be enough. Unlike a 401(k), neither Roth nor traditional IRAs are tied to an employer and can be opened up on your own like a regular bank account or brokerage account.
If you're early in your career, you will likely want to take advantage of a Roth IRA because you can pay taxes on the front end while you're in a lower tax bracket and let the money grow and compound tax-free. If you're at the height of your career and this is likely the highest tax bracket you'll be in, consider taking advantage of a traditional IRA because there's a chance you can deduct your contributions from your taxable income.
Everyone's situation is different
When it comes to retirement, you should keep in mind that there's no one-size-fits-all approach. There's no concrete annual number you'll need in retirement and no concrete total savings amount, but there are good rules of thumb that many people can use to guide their retirement savings plan. By no means is the 4% rule without its flaws, but if used as a proper baseline, it can be a beneficial tool.