Saving for retirement can be complicated for some, or easy for others. However, once you get there, you might ask yourself: “Now what?” Many may be afraid to withdraw from their savings, as they don’t want to miss profits in the market. Many might want to withdraw all the savings so they don’t hit a market crash. Fortunately, there is a 4% rule that is helpful for those looking to retire. This rule simply put means to withdraw 4% from your account each year, and the market will make up the rest. Let’s break it down step by step.
The Math
Let’s start with an easy number to do our math. Not everyone can get to $1,000,000 in savings, but many will. Let’s assume that there’s a retirement account with $1,000,000 and we apply the 4% rule for a yearly (or monthly) withdrawal.
4% of 1,000,000 = 40,000. This means if you have $1,000,000 in your account, and you withdraw 4%, you would withdraw $40,000 for the year. That would leave you with $960,000 in your retirement account. Over the next year, the retirement account with have time to replenish those funds through earnings in the market. The exact amount that the stock market will return on an investment is disputed, but many agree to a figure of around 10%. This means that your $960,000 will earn about 10% in one year (on average). At the end of the year, your $960,000 will turn into $1,056,000 (960,000+10%; or 960,000+96,000).
Year two, you can choose to increase your withdrawal amount, or you can continue to use the 4% rule. If you continue to use the 4% rule, you will have more than the $40,000 from last year. Now you will take 1,056,000-4% (or 1,056,000-42,240) for your balance. You will have withdrawn $42,240 in year two, and have an account balance of $1,013,760. The withdrawal rate stays at 4%, but since the market made up 10% of its value, you have more than you started. The extra $2,240 also helps with an increase in inflation.
Real Life Application
If you’re reading this and overwhelmed by the large numbers, just remember that $1,000,000 is a large amount of money, but it is a very realistic number for those looking to retire. Let’s take a quick break to find what you would need to get to $1,000,000.
For this scenario, we will assume you have 25 years to retire, and the market earns an average of 10% on your savings. For the first two years you save $5,000, years 3-6 you save $7,500, years 7-14 you save $10,000, and years 15-25 you save $15,000. Over 25 years you’ve saved a total of $285,000. However, with compound interest and growth in the market, your new balance is not $285,000, but $1,002,261.06. That means that $717,261.06 of your savings came from market growth. See the below chart to see your growth over the years.
Is $1,000,000 Enough?
Through this excercise we have been using $1,000,000 in savings as a standard, but this number is arbitrary. The true number is difficult to know, as it depends on where you live, when you retire, and your needs and lifestyle. $1,000,000 in 25 years may not be enough. More specifically, $40,000 as a yearly income may not be enough to live off of in $40,000. However, it is important to remember that after a few decades of financial responsibility, hopefully you’ve built yourself a budget, and paid off all of your debt, even a home.
The 4% Retirement Rule
The 4% retirement rule assumes quality growth of the market. It also assumes that you have a healthy amount saved when you retire. If you are nearing retirement and have closer to $100,000 than $1,000,000, then 4% is only $4,000, which is not enough money for one year. At this point, you may have to rely on Social Security, or plan to work a few more years and amp up your savings and amp up your debt payments. Ultimately, the market will never work at 10% perfectly each year, and there may be years that your account loses money. The plan works best with larger accounts and longer time periods. Continue to work hard at your financial literacy and find financial freedom through our financial literacy education. If you are looking for more information on stocks and the market, you can find more information here.
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