Building a retirement nest egg is not easy. For many people, it means making sacrifices like following a strict budget, keeping leisure spending to a minimum, and frequently reviewing investment portfolios to track their performance.
Given the effort you might put in saving for retirement, it's important to make sure your money lasts once you reach retirement. To that end, you need to establish a smart withdrawal strategy for your IRA or 401(k).
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Many financial experts say the 4% rule is still a good benchmark to follow in that regard. But there's a big misconception about the 4% rule that you don't want to get wrong.
How the 4% rule really works
The 4% rule was established back in the 1990s, and its purpose is to help retirees avoid running out of money. Following the 4% rule should, in theory, allow your savings to last 30 years.
You might assume that the 4% rule has you withdrawing 4% of your savings balance each year in retirement. But that's not exactly how the rule works.
With the 4% rule, you withdraw 4% of your IRA or 401(k) plan balance in your first year of retirement. But from there, you're allowed to increase your withdrawals each year as needed to account for inflation.
It's that latter point that some people tend to forget about. But just as Social Security benefits are eligible for an annual cost-of-living adjustment (COLA), so too can your retirement savings get an adjustment under the 4% rule.
So here's how the 4% rule might work. Let's say you have $1 million saved for retirement. Your first year, you'd withdraw $40,000. But if inflation rises 3% that year, then for your second year of retirement, you'd withdraw $40,000, plus 3% more, or $41,200, to account for the fact that costs went up broadly.
That said, the 4% rule assumes that your portfolio has a fairly even mix of stocks and bonds. If you're a very conservative investor and have 80% of your portfolio in bonds during retirement and only 20% in stocks, the 4% rule may not hold up well for you, because your savings may not generate enough growth to sustain that withdrawal rate.
Is the 4% rule right for you?
The 4% rule could give you peace of mind if you're worried about depleting your nest egg. But it may not be the best advice for you to follow.
For one thing, the 4% rule is supposed to help your savings last for 30 years. But if you retire in your late 50s, you might need your nest egg to stretch longer than 30 years. And on the flip side, if you retire in your mid-70s, you may only need to plan for 20 to 25 years of withdrawals, allowing you to take more money out of your savings each year.
The 4% rule also assumes that you're OK with spending down your entire retirement account in your lifetime. You may not want to do that. Rather, you may have the goal of leaving some money behind to your heirs.
Of course, if this is a goal of yours, it's important to keep at least some of your retirement savings in a Roth account. That's because Roth IRAs and 401(k)s are not subject to required minimum distributions the same way traditional IRAs and 401(k)s are.
Either way, while the 4% rule may be a good starting point to work with, it's not necessarily the rule of thumb you should follow. If you do choose to follow it, though, know that it allows for inflation-related adjustments, as opposed to locking you into an exact 4% withdrawal rate year after year.
