Follow 5 new rules instead
Many retirees rely on a common rule of thumb for retirement withdrawals known as the 4% rule. According to this rule, if you withdraw 4% of your portfolio each year and increase your withdrawals with the rate of inflation, you should have enough income to last your lifetime.
So what’s the problem? While the rule can provide a rough estimate for planning purposes early on, its embedded assumptions can actually work against you once you retire.
Here’s a brief look at some of the factors the 4% rule doesn’t account for, plus steps you can take to be sure you’re on track to retire comfortably.
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New Rule: Estimate the Tax Bite
Taxes are inevitable, even when you retire and may no longer have earned income. The 4% rule, however, does not account for them.
Your taxes will vary depending on whether you’re drawing income from taxable brokerage accounts, retirement accounts like 401(k)s and IRAs, or Social Security. For example, interest, dividends, and capital gains from a taxable brokerage account are taxed at preferential rates, while withdrawals from traditional IRA and 401(k) retirement accounts are taxed at regular income tax rates. Social Security income is runs through its own special formula that determines how much of it is taxed.
Thus, you can’t afford to ignore the sources of your retirement withdrawals because that will impact how much you pay in taxes. And that directly affects how much income you actually have to spend each year.
Consider two hypothetical retirees: Dora has $1 million in a taxable brokerage account while Doug has $1 million in retirement accounts.
Let’s say they are both unmarried and both expect $30,000 per year from Social Security. In addition, each will withdraw $40,000, or 4%, each year from their accounts. At first glance, it appears they’ll each have about $70,000 a year.
But consider how taxes affect their outcomes: Dora’s taxable income is $34,600, and she will pay only $300 in federal tax, leaving her with $69,700 each year.
Meanwhile, Doug’s taxable income is $48,650, and he’ll pay $6,665 in federal tax, leaving him with $63,335—roughly $6,000 less than Dora.
Ultimately, following the 4% rule may not give Doug the cash flow he needs. (Note: Depending on where each retiree lives, they may have to pay more in state or local income taxes.)
What to do instead: Prepare for the impact taxes will have on your retirement by understanding how your various sources of retirement income are taxed. Then run scenarios that show you how much your taxes will be as you draw on different accounts in retirement. This way you’ll have a clear idea of how much you will actually need to withdraw to meet your income needs, and understand which accounts to draw down first to maximize tax efficiency.
Get expert help running personalized tax scenarios.
New Rule: Don’t Overestimate Inflation
The 4% rule builds in an inflation adjustment each year. That’s appropriate because retirees do need to account for rising prices. But there are two reasons they may need to factor in a lower rate than the general inflation rate.
Research by David Blanchett, head of retirement research at Morningstar, shows that spending is at its highest during the early years of retirement. Spending actually decreases in the middle years, and then increases again in later years, primarily due to health care needs.
Blanchett also found that inflation has the biggest impact on low-spending households—those spending less than $50,000 per year. This makes sense, as the rising prices of good and services represents a greater portion of those households’ income.
For households spending $100,000 or more in retirement, inflation has less of an impact. That means, their income may not need to go up at the same rate as inflation.
Example: Let’s say a high income couple starts taking $40,000 a year, and increases it at a general inflation rate of 3% annually. In 20 years, that couple is withdrawing just over $70,000 a year. But if the same couple starts taking $46,000 a year and increases it by 2% a year, in twenty years, they’re taking out $67,000 a year.
Both scenarios have planned for inflation. But in the later situation, you have more to spend during what Blanchett calls the high-spending “go-go years.”
What to do instead: Structure your withdrawals and inflation adjustments to match natural spending patterns and income levels.
Get expert help creating an income plan – customized for your unique financial situation.
New Rule: Create a Contingency Plan
The 4% rule works to ensure you won’t run out of money, even during the worst market downturns. It does so by assuming that every year could be a bad year, essentially keeping you in a state of perpetual austerity.
However, it’s highly unlikely every year will be a bad year. And that means you may be able to withdraw more money in some years than others.
What should you do instead? Try to strike a balance by creating contingency plans that keep you from overdrawing when your portfolio is weak. Here are a few ideas:
- You could reduce or increase your withdrawal rates depending on predetermined conditions such as the size of your portfolio relative to how much you’re withdrawing.
- You may decide you can withdraw a certain amount of money as long as your portfolio stays above a given threshold, and lower your withdrawals if your portfolio falls below it.
- You may choose to use a dynamic withdrawal rate. For example, in any year that your portfolio experiences negative returns you could skip your inflation increase.
Finally, you may also consider contingency plans that involve changes in lifestyle, such as planning to downsize your home to free up equity in your later retirement.
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