We all know we're supposed to save a decent chunk of money for retirement so we have the ability to live comfortably once we stop working. But how much savings is enough?
One good way to know is to see how your balance looks and figure out how much yearly income it can give you under what's known as the 4% rule. Established in the mid-1990s, the 4% rule has long been the standard when it comes to yearly retirement plan withdrawals. Yet a surprising number of Americans have never even heard of it. In fact, in a New York Life survey, 77% of adults 40 and up either overestimated the amount of money they could safely withdraw each year in retirement, or owned up to having no idea about the type of withdrawal rate they should aim for.
And that only means one thing: Workers across the board had better not only read up on the 4% rule, but also start developing their own yearly withdrawal strategies. Otherwise, they'll risk not saving enough or prematurely depleting their nest eggs down the line.
The 4% rule: A solid starting point
The 4% rule states that if you begin by withdrawing 4% of your savings during your first year of retirement, and adjust subsequent withdrawals to account for inflation, there's a good chance your savings will last for 30 years. And while that might seem like too lengthy a period to plan for, keep in mind that life expectancies today are longer than what they were in years past. Nowadays, one out of every four 65-year-olds will live past the age of 90, while one in 10 will live past 95. Since 62 is the most popular age to claim Social Security, and many workers file for benefits and retire simultaneously, you can see why it's advisable to plan for a 30-year retirement.
And that's why the 4% rule, though not perfect, is a pretty good rule of thumb. While there are different annual withdrawal rates you might play around with, as opposed to locking yourself into 4% from the start and sticking with it throughout retirement, it's critical to have a sense of how much you can afford to withdraw from your nest egg each year, even if that figure is just a ballpark. Yet most Americans aren't even aware that 4% should be their starting point.
How long will your savings last?
Another reason it's smart to apply the 4% rule to your savings is that it'll help you determine whether you're in good shape for retirement, or whether you'll need to start doing better.
Say you're in your mid-60s and are planning to retire within the year. Let's also assume that at present, your retirement plan balance is $500,000. Now that might seem like a pretty decent chunk of savings, but when we apply the 4% rule, we see that that balance allows for roughly $20,000 a year in income. Now if you're eligible for Social Security benefits, which is likely the case, you'll want to factor those into your annual income as well, but since the typical recipient today only collects between $16,000 and $17,000 a year, all told, that's not a ton of money to live off. Therefore, you might, in this scenario, decide to postpone retirement for two or three more years and save aggressively during that period.
Here's another way to use the 4% rule. Say you're in your mid-40s with two decades of work ahead of you, and you're trying to determine how much to save before you can comfortably call it quits. If you estimate your annual living expenses in retirement at $48,000, of which $16,000 will presumably come from Social Security, that leaves you with a $32,000-a-year gap to fill. Using the 4% rule, you can then multiply $32,000 by 25 to arrive at a personal savings goal of $800,000.
Of course, not only is the 4% not flawless, but it's also not exact. You may come to find that you're safer withdrawing 3% of your nest egg each year to ensure that it lasts. Or, you may decide that you're able to swing a 5% average annual withdrawal rate. The key, however, is to develop some sort of withdrawal strategy during your working years, even if it's just an estimate. It's a far better bet than going in blindly and coming up short in retirement as a result.