Planning for retirement isn't something that can be done overnight -- it takes decades of hard work and preparation.
For many people, the biggest struggle is saving enough for retirement. One in five Americans has nothing at all saved for retirement, according to a survey from Northwestern Mutual, and money is also the No. 1 source of stress among the survey participants.
However, saving is only half the battle. Even if you spend your entire career saving diligently, one simple mistake in retirement could wreck your plans for the future.
Why spending wisely is a critical component of retirement
You've spent years socking away money for retirement, and then once you're finally retired, it's time for the fun part: spending your hard-earned cash. It may be tempting to go a little wild your first few years of retirement, checking off all the activities on your bucket list. But if you let your spending get out of hand, it could throw off your retirement plans for the rest of your life.
You risk running out of money down the road by withdrawing too much each year from your retirement fund. Even if you only go slightly over your budget, all that money adds up over time. For instance, if you withdraw just $5,000 per year more than you intended for 10 years, that's $50,000 you've overspent. Depending on how much you need to get by each year, that could be a year or two worth of retirement income.
Also, if you withdraw more than you should, it's tough to get back on track when you're living on a fixed income. Unless you pick up a job in retirement, you may not be able to save any more than you already have. You might be able to grow your savings if the stock market experiences an upswing and your investments benefit from higher rates of return, but there's no guarantee that will happen. You could also withdraw less over the following years to make up for the years you spent too much, but if money is already tight, you may not be able to cut costs enough to get back on track.
To avoid that scenario, make sure you have some type of plan in place before you retire to ensure you don't withdraw too much too soon.
How much can you safely withdraw each year?
There are a few types of withdrawal strategies you can use when determining how much you can take from your retirement fund each year.
One of the most popular strategies is the 4% rule, which states that you can withdraw 4% of your savings during the first year of retirement, then adjust that number each following year to account for inflation. So if you have, say, $750,000 saved for retirement, you can withdraw $30,000 your first year. Then if inflation runs around 3% per year, that means you'd withdraw $30,900 the next year. By withdrawing at this pace, your savings should last around 30 years.
The 4% rule is a good starting point, but it does have its flaws. For example, it assumes you're going to be spending the same amount every year of retirement. But it's likely you'll need more money some years than others, particularly as you age and as healthcare costs increase. That said, the 4% rule can get you in the right ballpark with your spending so you have a rough idea of how much you can withdraw each year.
For a more flexible approach, you may opt for a more dynamic withdrawal strategy that allows you to adjust your withdrawals yearly to fit your unique situation. For example, if you're seeing lower rates of return on your investments, you may need to withdraw slightly less that year so your savings last longer. But when you see higher returns, you could be able to splurge and withdraw more. Or if you find out you may face expensive healthcare costs in the future, you can adjust your spending now so you have more cash saved for those expenses.
A dynamic withdrawal approach allows you to roll with the punches, which makes it more flexible than the 4% rule. However, it's also more complicated, and you may need help from a financial advisor to figure out exactly how much you can withdraw each year.
Regardless of which type of strategy you choose, it's also important to think about how taxes will affect your withdrawals (assuming your savings are invested in a 401(k) or traditional IRA and you'll owe taxes on your withdrawals). If you opt for the 4% rule, for example, the amount you can withdraw each year is the total amount you can spend -- meaning it needs to cover all your expenses plus taxes.
At the end of the day, the most important thing is that you have some type of withdrawal strategy. If you choose to wing it and hope for the best, you may end up spending too much each year of retirement and your savings will run dry too soon. But the more you plan, the better your chances are at having your money last the rest of your life.