The 4% Rule

If you’re ever thinking of retiring, you should familiarize with the 4% rule. The basics of the 4% rule: when you “retire”, calculate what’s 4% of your nest egg*¹, and withdraw no more than this amount annually (adjust/increase each year for inflation), and your nest egg will*² never be depleted throughout your retirement*³. Why 4%? Without getting scientific, let’s say your portfolio averages gains of 8%/year (adjusted for inflation), if you withdraw 4% each year, the portfolio balance will still grow on average about 4%, but there will be some market volatility. If the market drops 5% annually for 2 consecutive years, a 4% withdrawal rate should safely get you through those down years. Many early retirees that live by this rule, live a full life and pass with more than they began with.

So let’s work backwards and find out what this means to you (kinda started on this in the last post). If I can only withdraw 4% per year, how big does my nest egg need to be to live off of? Calculate your desired annual spending. $50,000 sound good? So 50,000/4% = $1,250,000. Your nest egg needs to be at least $1,250,000. As explained in the last post, this number is your net worth (Assets – Liabilities) excluding your primary or vacation residence(s).

Ok, well let’s address that pesky thing called taxes. If you’ll be withdrawing from your taxable trading account, you’ll be taxed at the long-term capital gains rate. How much will this cost ya? Well if you are married like me, and withdrawing up to $75,900 in GAINS (and reporting no other income), your tax rate will be 0%. You read that correctly, zero percent. For singles, the max is $37,951. If you’re withdrawing from an IRA or other tax-advantaged, retirement account after age 59½, your withdraws will be taxed as if they are ordinary income. Let’s stack on top of that a $24,000 standard deduction for a couple or $12,000 for an individual. This means you could withdraw almost $100,000 in capital gains per year, and still pay 0% in taxes… Again, assuming you have no other income.

Now I gotta address all the asterisks in the first paragraph:

¹ The contents of your nest egg REALLY matters, especially if you wish to retire long before age 59½. You’ll need enough money in taxable brokerage accounts, Roth contributions, rental income, and other liquid assets to get you to age 59½, before retirement accounts become an option. An example of a less than ideal situation… An acquaintance told me he’s really feeding his 401(k), has over $250k already, is 31 years old, and has less than $10k liquid.  Awesome job saving man, but it’s gonna be really tough for that to help you reach financial independence anytime soon. His 60s are looking promising, but what about until then? Withdrawing from the 401(k) before 2047 would cost serious IRS penalties and taxes. I suggested he may consider stop putting money into the 401(k), because even if he never contributes to this account again, it averages 8% annual growth, the account will have over $2mil by age 60. Gotta love the power of compounding! He has changed his focus to putting money into accounts/investments that can generate usable income right away.

² If there is not a prolonged economic meltdown early on, you should still be good. Let’s say you kicked off your early retirement in mid-2007, just before the great recession. Withdrawing 4% of your portfolio in those first couple years would’ve really set you back. If you start retirement just PRIOR TO one of these falls/recessions, you’ll probably need to put some more money away or take a smaller withdrawal rate, like 2% to ensure it lasts. However, if you hit your target number DURING one of these recessions, you’ll be living large. You could probably bump up to a 5% withdrawal rate.

³ Your funds must be INVESTED wisely where they’ll grow with the market. This whole plan won’t work if your money is sitting in purely bond funds, or even worse, a savings account. (I’ll talk basics of investing in a future post). You’ll also need to have discipline to not withdraw more than 4% annually, especially in the early years. If you want to splurge and take some expensive trips or buy some toys, it’d be wise to earn that money outside of your nest egg.

There’s obviously a lot of science and support for this whole 4% rule, and I can in no way include it all here. I encourage you to search out and find more context from the experts out there, but this should give you some good ground to start from.

More material to nerd out on:

Investopedia – Four Percent Rule

CNN Money – Should you follow the 4% rule?

Kitces – How has 4% rule held up since 2008 financial crisis?

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