Ideally, you'll enter retirement with a healthy chunk of savings, whether in a 401(k) or IRA. But you'll need a plan for accessing that money. You don't want to just randomly take withdrawals from savings, because that's a good way to deplete your nest egg prematurely. Rather, you'll need to establish a reasonable yearly withdrawal rate in the course of your retirement planning to both preserve your savings and also get a good idea of how much annual income to expect.
For years, financial experts have been advocating the 4% rule, which came into favor back in the 1990s. The 4% rule is simple: Start by withdrawing 4% of your savings balance your first year of retirement. Then, stick to that rate but adjust subsequent withdrawals for inflation. Follow that plan, and your savings should last a good 30 years.
At first glance, that might seem like a great system. Based on average life expectancies, if you were to retire in your 60s and get 30 years' worth of income out of your nest egg, you'd be in a good position not to run out of money in your lifetime.
There's just one problem with the 4% rule: It's outdated and based on assumptions that may not apply to your specific retirement portfolio. And that's why following it could actually be a dangerous thing.
Problems with the 4% rule
When the 4% rule was established, bond yields were much higher than they are today. Why's that relevant? Seniors are often advised to shift toward bonds to avoid the volatility of stocks. As such, by the time you retire, it's generally wise to have about 50% of your assets in bonds. But bonds today aren't paying what they did back in the 1990s, and in the absence of adequate growth in your portfolio, you could wind up depleting your savings prematurely if you stick to the 4% rule.
Here's another issue with that rule: It assumes a relatively equal split of stocks and bonds in your portfolio. But what if that's not what your asset allocation looks like? What if you're the conservative type who's gone heavier on bonds than the average senior? If so, sticking to the 4% rule could leave you with a serious income shortfall over time.
A safer alternative
The 4% rule is a good starting point when sitting down to determine how much of your savings balance you can afford to withdraw each year. But it may not be the best solution for you. If you're heavily invested in bonds, removing that much of your savings each year comes with risk, and so in that scenario, you may be better off sticking to a far more conservative withdrawal rate, like 2% or 2.5%. And if that's the case, it's important that you come to that realization before retirement, not during it, so you're not thrown for a financial loop.
Imagine you retire with $1 million in savings. Sticking to the 4% rule would give you $40,000 a year in income, at least to start with. Going with a 2.5% withdrawal rate gives you $25,000 a year from savings to live on instead. The absence of that $15,000 could inform other retirement decisions you make -- what state you retire in, whether you keep your home or downsize, and whether you opt to work part-time to supplement your income -- so it's important to establish your withdrawal rate before your career comes to a close.
Of course, you may find that the 4% rule works for your situation. But following that rule without digging into it could result in a world of financial stress during your senior years, so don't assume that it'll work for you just because it's worked in the past.