3 Important Things to Know About the 4 Percent Rule

The idea of outliving your retirement savings is enough to keep anyone up at night. That's why it is imperative to adhere to a proven system when calculating how much money you can comfortably withdraw annually from your retirement nest egg without putting yourself or your family at financial risk. One popular path to solving this problem is to use the 4 percent rule. Many people have heard of the 4 percent rule of thumb, but most don't completely understand its meaning or how to make it work in their retirement situation.

What Exactly is the 4 Percent Rule?

The 4 percent rule became a standard retirement strategy after a financial advisor named William Bengen conducted a study in 1994. His research used historical stock market information from 1926 to 1976. Bergen concluded that regardless of market performance, withdrawing 4 percent from a balanced investment portfolio won't wholly deplete available monies for 33 years at a minimum; significantly longer than the typical retirement. Generally, it is believed that this retirement strategy is safe, considering the time period Bengen chose includes two severe market downturns. In fact, the rule is also known as SAFEMAX because it is the maximum amount which can be safely removed from a portfolio. 

Bengen later increased the safe percentages from 4 percent to 4.1 percent if you have to pay tax on your withdrawals, and 4.5 percent if you don't; but most people continue to call the strategy the 4 percent rule and use the original 4 percent when calculating their retirement withdrawals.

While it is  a very popular retirement strategy and is effective for many people, this particular retirement strategy may not be a suitable solution for everyone. These are three very important caveats you need to be aware of before adopting the 4 percent rule. 

Three Important Things to Know About the 4 Percent Rule

1. Discipline is Necessary

People who choose to follow the 4 percent rule will have to resist the urge to splurge when the market is doing well. This is particularly difficult when you are getting returns which far exceed 4 percent year after year, and you feel that you are cheating yourself by limiting your withdrawals. Remember that what goes up must come down, and the 4 percent strategy is for the long haul. 

2. Certain Types of Portfolios May Not Fit

The data Bengen used for his study was based on the overall performance of the market. That means that if you have about 60 percent of your retirement funds invested in low-risk investments such as index funds and 40 percent of your retirement money in bonds, then the 4 percent rule should work over the long term. On the other hand, if you hold a lot of high-risk investments, you are in a much more precarious situation, since a downturn may decimate your portfolio, and you may never be able to make back the money you lost. 

3. Be Aware of Required Minimum Distribution Penalties

For some investments, such as IRAs, 401(k)s and others, you may have to withdraw a minimum amount per year or face a substantial excise tax of 50% of the amount you were supposed to, but did not withdraw. The date when these minimum distribution penalty requirements go into effect depends on the type of investments when you retire, and your current age. You can find more specifics on the IRS website. This may mean that to avoid the penalty, some years you may have to take out more than you planned. 

You only get one shot when it comes to preparing for retirement, and maybe the 4 percent rule is not the best option for you. A qualified financial advisor can help you set up a good plan for your retirement which takes into consideration your lifestyle, goals, and financial means.