Can you rely on the 4% rule to sustain your retirement?

Once you reach retirement, it’s time to make the best use of the assets you’ve accumulated. But arriving at the right amount to spend each year can be tricky.

Spend too much and you could compromise the goals you’ve set for you and your heirs. Spend too little and you may not fully enjoy the benefits of your wealth.

Finding the right balance means determining a withdrawal rate that is sustainable over what could be decades of retirement. It’s a key consideration that influences your general lifestyle and has investment, wealth transfer and tax implications.

But how do you determine your optimal withdrawal rate?

Is the 4% rule the solution?

You may have heard of the so-called “4% rule.”

It suggests you won’t outlive your assets if you withdraw 4% of your total portfolio value in the first year of retirement, then adjust withdrawals for inflation each year after that. The concept is based on historical market data, and it’s intended to provide a simple and reliable approach to spending during retirement.

But the rule can lead you astray. It is based on a range of assumptions that seldom all line up to your situation. These include:

• Having a single portfolio invested in a 50/50 mix of equities and fixed income
• Withdrawing funds over a 30-year time frame
• Using historical investment returns (as the disclaimers always say, “past performance does not guarantee future results”)
• Withdrawing the same amount each year (adjusted only for inflation)
• Not caring whether you have any assets left for inheritance

In addition, it doesn’t give any consideration as to whether you’re withdrawing from taxable, tax-deferred or tax-free accounts.

Determining the right amount for you

Rather than rely on a generic rule, your personal circumstances should drive how you spend your assets in retirement. This means deciding on each of the following:

• Your goals. Goals don’t have to be set in stone, but identifying long-term and short-term goals helps categorize your spending. For example, do you want to travel the world? Do you plan to buy a vacation home? Help pay for grandchildren’s education? Major goals like these can have specified dollar amounts attached to them, which provides a baseline withdrawal rate for you to evaluate. Once you outline your lifetime goals, you can determine if they are achievable and start to work out an idea what’s available for average annual spending, taking inflation into account.
• Your time horizon. How long will your retirement last? The 4% rule’s 30-year retirement assumption is an average estimate. Yours may be longer or shorter. Over time, average life expectancy has risen, such that retirement cashflow often can now go out for 35 or 40 years. For example, if you are retiring in your 50s, you have close to half your life to plan for. Similarly, if you have longevity in your family history and are in good health, a longer timeframe may give you better peace of mind.

Also, the timing of your goals is a factor. For example, do you plan to travel now or in five years, or later? If you’re helping fund higher education, how far are your grandkids away from college?

• Your legacy. You may want to plan beyond your lifetime: do you have wealth-transfer goals? Earmarking how much you want to leave for future generations helps set the parameters for your own retirement funding. This legacy amount is $0 under the 4% rule. That’s not often the case, especially for individuals with children or other close family members. This amount doesn’t need to be precise, but identifying assets or a level of financial security you would like to leave to someone should be a critical part of your retirement plan.
• Your investment strategy. For some, restricting your withdrawals to the income generated by your investments can feel like the most prudent approach. You rely on investment income and leave the principal untouched. But be careful. Relying only on investment income can lead to an overly conservative approach, both in relation to what you spend and your investment strategy. Targeting interest and dividends as the goal of your portfolio can skew your investments away from a more optimized mix of risk and return, which in turn can undermine achieving your long-term goals.

Determining the right investment strategy depends on the decisions listed above. It also involves factors like inflation and tax status. Ultimately, you need to feel comfortable with your investment strategy. But the key to finding that comfort is understanding your goals and participating in the analysis that can optimize your investments to achieve them.

Don’t forget about taxes: Where you draw from matters

Most people have a mix of taxable investment accounts, plus tax-deferred and non-taxable retirement accounts. In addition to the basic goals analysis, your withdrawal strategy should be optimized to reflect the income taxes you may have to pay on each withdrawal, depending on where the money is coming from.

The general guideline is to first withdraw from taxable accounts, including investment or brokerage accounts. You have already paid taxes on these assets, so liquidating them typically involves only the realization of any capital gains.

Second, look to assets from tax-deferred retirement accounts, starting with your traditional IRAs or 401(k). Delaying withdrawals from your retirement accounts until you need the money is generally a good idea. Under current rules, you have until age 73 before you must take required minimum distributions (RMDs), which are taxed as ordinary income when withdrawn from a traditional IRA or 401(k). If you were born in 1960 or after, RMDs begin at age 75. The longer you wait, the more time these assets will have to appreciate. This is especially true with the last bucket you typically want to withdraw from, which is your tax-free Roth IRAs or 401(k). Roth accounts are not subject to RMDs during your lifetime. Withdrawals also are not subject to tax. This means the benefits of deferring distributions are even greater.

It’s important to consider that tax laws change over time. Tax brackets may move, capital gains rates may change and, as recently happened, the rules changed for an inherited IRA, requiring the beneficiary, in certain instances, to drain the account within 10 years.

But like the “4% rule,” these general guidelines should be adapted for your circumstances. If you believe you’ll be in a higher tax bracket later in retirement, you may not want to defer your withdrawals. Alternatively, if you have a particularly high year of income early on in retirement, you may want to postpone distributions you otherwise might take.

Also, as with your goals, remember that your tax circumstances may change over time. Take into account changes that you can plan for: a move to a new state, for example, or the sale of a business that will bring new liquidity or may alter your tax and overall asset picture.

If your goal is to leave significant assets to heirs, that also may change your withdrawal strategy. In some cases, drawing from your tax-deferred retirement accounts first, before taxable investments, may make sense. Taxable investments and tangible property (real estate, art, antiques) that have increased in value receive a “step-up” in income tax basis to current value at your death. Holding onto these assets to pass by inheritance eliminates capital gains tax, which you would have needed to pay if you sold the appreciated investments during your lifetime.

Plan now, adjust later

While the 4% rule provides a general guideline that can provide peace of mind in some situations, the truth is there is no one rule that works for everyone. Defining the right withdrawal rate for you requires close analysis tied to factors and assumptions tailored to you. Each of those can change as your life evolves.