The 4% Rule. What is it? If you’ve been around the block of Financial Independence or Early Retirement (FI/RE) you have probably seen this come up. On its surface, it’s a simple rule of thumb. It guides how much money you can take in retirement and helps you determine how much you need.
Unsurprisingly, it goes deeper than that. This is the first video in a three part series where I discuss what the 4% Rule is and its effect on financial planning. Let’s get started.
WHY I CARE ABOUT THE 4% RULE
The 4% Rule was the first thing that got me hooked on the idea of getting to Financial Independence early. I learned that I could multiply my annual spending by 25 and have a savings goal for Financial Independence. Nice simple math! Other thoughts quickly followed:
After this series, there will still be plenty of unanswered questions: “What what are the criticisms?” “How and why has the 4% Rule changed?” “What else do I need to consider?” Good questions, but for now, I’m just going to stick with the “birth” of the 4% Rule, not the toddler years or beyond.
4% RULE: DEFINITION
The 4% Rule is a rule of thumb that guides a retiree to the amount of savings that can be withdrawn each year of a 30 year retirement. It was designed so that a retiree would maintain their current standard of living, by accounting for inflation. For a person planning on a 30 year retirement, 4% is the Safe Withdrawal Rate for the first year.
HOW TO USE THE 4% RULE
YEAR 1 OF RETIREMENT
If you were to use the 4% Rule in retirement, you would withdraw 4% of your portfolio during your first year. This is the amount needed sustain your current standard of living. For example:
Say you have $1,000,000 in savings
That’s it. That is when the 4% is used. The first year.
RETIREMENT YEARS 2-29: HANDLING INFLATION
The 4% Rule has a very simple (and simplistic) answer for dealing with inflation and the rest of the “29” years of retirement. After the first year, you withdraw the same amount as the previous year plus inflation. Back to our example.
Let’s assume an average 3% inflation during year #2:
Now, let’s assume 3.5% inflation for year #3:
As inflation varies, so does the amount that can safely be withdrawn from savings. The 4% Rule says that you should, in almost all cases, have enough money to sustain your current standard of living all the way to that 30th year.
The “4% Rule is also used to calculate your savings goal. To do that, multiply your annual spending by the inverse of 4%. Divide 1 by 4% to get the inverse.
Fun fact, this is why the “4% Rule” is also called the “Multiply by 25 Rule.”
Using the same example as above, let’s say you want to be able to withdraw $40,000 during your first year of retirement. How much do you need in savings?
That, at its most basic level, is the 4% Rule.
Why 4%? Who came up with it? If you, like me, aren’t comfortable with just that simple number, continue on.
A link to the second video in this series will be here after it has been posted.