Retirement is supposed to be a time of simplicity, when you relax, spend your time however you want, and live on your hard-earned savings. Unfortunately, your retirement probably won't have the kind of financial simplicity you're dreaming about. As a retiree, you'll have important financial decisions to make. And one of the biggest of those decisions is how much money you can and should be taking out of those retirement savings accounts every year.

The 4% rule

Money experts love to come up with rules and give them catchy names. Some of these rules even work, but because economic and financial environments are always changing, even the best rule typically doesn't work forever. The 4% rule is a great example. It was first developed in 1994, based on the work of a financial analyst who studied historical stock and bond returns. He concluded that a retiree could withdraw 4% of their savings annually for at least 30 years without running out of money. If you like, the rule allows you to adjust your annual withdrawals for inflation, meaning that you would increase the withdrawal amount by the inflation rate for the year.

Cash in envelope labeled '401k'

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Problems with the 4% rule

The 4% rule provides a neat, tidy way to plan retirement withdrawals. Unfortunately, this may not work as well today. It was based on historical stock returns and interest rates well before the Great Recession. Accounting for the near-zero returns of the "lost decade" of 2000-2009, the data no longer supports the idea that a 4% withdrawal rate for 30 years is completely safe. And with people living longer than ever, you might even need to look beyond 30 years as a retirement time frame. So as nice as it would be to rely on one simple number, if you want to be fairly sure that you won't outlive your money, you'll need to customize your withdrawal amount to your own situation.

Financial factors

Before you can decide how much you can safely take from your retirement savings accounts, you need to decide just what your goals are for that money. One of the biggest considerations is how long you want your retirement accounts to last. This will depend chiefly on your retirement date and expected lifespan, since these factors together will determine just how long your retirement will be, but there may be other issues to consider as well. For example, do you want to have some money left over to leave to the kids or grandkids? If so, you'll need to be a lot more conservative in your spending than someone with a "you can't take it with you" mentality. Once you've decided how long you want your retirement accounts to last (be generous here; it's better to have your money outlive you than vice versa), the other major factor to look at is how well your portfolio has performed during the year.

Coming up with a magic number

Let's look at a couple of scenarios for calculating how much you can safely withdraw from your portfolio. First, imagine a 67-year-old in good health whose retirement portfolio grew by 6% over the last year. Actuarial tables give him an expected lifespan of roughly 20 years, but that only means that he has a 50% chance of living less than that and a 50% chance of living longer, so he'd better allow for at least 30 years of retirement for financial planning purposes. At this point, he'd be wise to be conservative about how much he's going to withdraw. Since his investments grew by 6%, if he limits himself to taking 3% of the new balance at the end of the year, he's keeping some of that growth tucked away to make more money for him in the years to come.

Now contrast that retiree's situation with that of an 80-year old retiree with the same annual return. Unless he's Methuselah, he doesn't need to plan for a 30-year retirement window, so he can safely take a little more from his savings. A 5% withdrawal at this point would be safe; his portfolio might shrink a little as a result, but unless he's having trouble supporting himself, this shrinkage won't pose a significant risk to his financial future. However, if he's determined to leave as much as possible to his heirs, he might stick to a 4% withdrawal for the year instead so that he can keep his portfolio flourishing for them.

Market matters

By the time you're well into retirement, most of your retirement savings are probably in bonds, with the remainder in stocks (although some advisors recommend keeping as much as 60% of your investments in stocks during retirement). Bonds might be less volatile than stocks, but they're certainly not immune to economic pressures; a bad year can result in stagnation or even a loss. When the amount of capital you have tucked away in your accounts shrinks over the course of the year, you need to factor that into your decision of how much money you can safely take. Selling off too big a chunk of your investments will cause your income (in the form of interest payments from bonds and dividends from stocks) to drop off in the following year, meaning that you'll have less money coming in and will therefore need to take more out of your retirement savings accounts just to get by. That can set off a vicious cycle where you continually need to sell off more and more investments each year, further reducing your income from those investments.

How to keep your portfolio alive

If your investments have taken a beating over the last year, you'll want to minimize your retirement account withdrawal. In fact, if you can manage it, the safest course of action would be not to take any money out at all. This may require you to find other sources of income for the year, such as taking a temporary job or renting out a room of your house. By the end of the following year, it's likely that your investments will be prospering again and you can take a normal withdrawal of somewhere between 3% and 4% (or more, as you age). Cutting back on your retirement account withdrawals may seem like a hassle -- and it will be -- but it's sure a lot better than running out of money entirely.

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