After years of stashing money away for retirement, the day will come when you need to start spending that hard-earned cash. Question is, how much can you afford to withdraw each year without outliving your money? The 4% rule is a common approach to resolving this challenge.

What is the 4% rule?

The 4% rule limits annual withdrawals from your retirement accounts to 4% of the total balance in your first year of retirement. That means if you retire with $1 million saved, you’d take out $40,000. According to the rule, this amount is safe enough that you won’t risk running out of money during a 30-year retirement.

The 4% rule Open in new tab also assumes that you have about 50% of your investments in equities or stocks, and 50% in fixed income assets like bonds. Furthermore, the assumption is that the funds are held in a tax-deferred portfolio like a traditional IRA or 401(k) and that you’ll owe tax on withdrawals.

You’d also adjust this amount annually for inflation. For example, you might choose to increase withdrawals by a flat 2%—the long-term historical rate of inflation—each year. Or you might base increases on each year’s actual inflation rate.

Why the 4% rule used to work (and still might)

Financial advisor Bill Bengen designed the 4% rule in the 1990s as an easy-to-follow plan for accomplishing two critical things: Covering your costs throughout retirement while making your money last as long as you do. By considering both average returns and unexpected events like the 1929 market crash, Bengen determined that a retirement portfolio made up of 60% equities and 40% fixed income assets should last over 30 years if you withdraw only 4% of the total amount annually.

According to Bengen’s model, even if you retire just before a financial crisis, the negative effect on your portfolio would be mild enough to ensure at least 35 years of living expenses. In 1990, he advised that the average American man was expected to live about 15 years after age 65, and the average woman just under 20 years. So, the 30-year buffer made it seem like a safe—even conservative—approach to making retirement savings last a lifetime.

The 4% rule comes with a major caveat: It’s not really a “rule” since everyone’s situation is different. If you have a large retirement investment portfolio, you might not need to spend 4% of it every year. If you have limited savings, 4% might not come close to covering your needs.

Even Bengen tweaked his own rule over the years. More recently, he advised that withdrawing 4.5% the first year would be safe. However, with inflation over the last few years, the 4% rule may not be enough, even if you spend on the same items. Think of this rule as more of a guideline you can adapt to your circumstances and lifestyle.

Risks of the 4% rule

Retirement expenses aren’t the same each year. Life spans aren’t always predictable, either. Here are some key risks to consider before you adopt this (or any) set spending rule:

• Sequence of returns risk. If the market experiences more downturns than upturns early in your retirement, your retirement savings may not last as long as it would if the down years come later.
  
• Health risk. Aging means more doctor’s appointments and medical bills in retirement—over $300,000 for the average 65-year-old couple. With these additional expenses—often unplanned and unexpected—it’s important to plan ahead.
• Longevity risk. The average life span has increased by a few years since the 4% rule came around (at least before the COVID-19 pandemic). But keep in mind that not everyone is average. According to the U.S. Census, more than 60,000 women (and nearly 15,000 men) were over age 100 in 2020.
• Market risk. You’ve heard it before: History doesn’t guarantee future performance. We could see unprecedented periods of inflation or market crashes that the 4% model doesn’t account for.
• Social Security risk. The 4% rule assumes that you’ll also receive the full Social Security benefits you expect based on your age, career earnings, and when you start taking them. But there’s a chance these payments could decrease by the time you retire. (The Social Security Administration has warned that its trust fund could run short by 2035; however, Congress could act before then to make sure the program stays solvent.)
• Spending risk. Expenses may fluctuate year by year depending on your life circumstances. Years with higher inflation rates could mean an indirect impact on how much more you’ll need to spend on necessities.
• Tax risk. The more you withdraw from your retirement accounts, the more you may need to pay in taxes.

Other retirement drawdown strategies

Consider modifying the 4% rule or using a completely different approach:

• Spend more conservatively. You might need to spend less in retirement to feel secure that you won’t outlive your savings if and when volatility increases and there is a risky period in the markets. For example, investment advisor Morningstar recommends starting by withdrawing just 3.3% Open in new tab from a retirement account. You could then increase withdrawals during good years—or even every year if you’re comfortable with less certainty that your portfolio will last the rest of your life.
• Make dynamic withdrawals. Instead of sticking to a rigid withdrawal rate, this strategy takes into account market swings. When markets are doing well, you can increase the amount you withdraw. That way, when there are lower or poor market returns, you can reduce your spending and the amount you withdraw.
  
• Spend your required minimum distribution (RMD). If most of your retirement savings are in a 401(k) or a traditional IRA, you could spend only what the IRS says you must take out each year, starting at age 73. RMDs are based on both how much money you have in retirement accounts and your life expectancy. Depending on your circumstances, this approach could yield more or less spending money. Also, it will only work if your RMD is enough for you to live on each year. Roth IRAs don’t trigger RMDs, and withdrawals aren’t taxable if you meet basic criteria. You’ll have to decide on your own strategy for how much to withdraw from a Roth IRA. Because Roth income is tax-free but traditional income sources aren’t, that decision could come down to your tax bracket.
• Use the bucket strategy. This approach involves separating your assets according to when you’ll make withdrawals. The point is to create a cushion of cash during the earlier years of your retirement and maximize the rest of your nest egg over the long term. More specifically, you can create cash buckets Open in new tab to afford the first five years of living expenses. The rest is for long-term growth goals. You can even divide the buckets further, creating one for medium-term growth and another for long-term growth.
• Maximize other income sources. If you’re able to cover your retirement expenses with other income, you could conserve more of your nest egg. If possible, consider delaying your Social Security payments until age 70. That way, you’ll receive your maximum monthly benefit. Also consider working part-time (if you can) to generate extra income.

Determine your personalized spending rate

No single rule will account for your specific circumstances. To determine your personalized spending rate, consider factors like your local cost of living and how long you expect to live based on your health and family history. Don’t forget to account for where you expect to retire and any one-off expenses you may have, like buying a new car.

Once you’ve determined how much you may need during retirement, consider using tools like a retirement calculator. Doing so can help you understand how much you’ll need to invest to reach your retirement goals.

Checking on your investments regularly is crucial to making sure they’re working for you.

Author Details

Sarah Li-Cain is an Accredited Financial Counselor®, writer, and podcast producer whose work has appeared in Fortune, USA Today Blueprint, CNBC Select, the Seattle Times, and many others.

Disclaimer

Prudential does not provide tax or legal advice; please consult an independent tax advisor regarding your personal tax situation.

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