Retirement is full of financial unknowns. How much can you safely withdraw each year? How long until your money runs out? How many years of income will you need? The 4% rule is a tool that helps you estimate how much money you can spend in retirement each year without running out of money for at least 30 years.
According to the 4% rule, you can withdraw 4% of your investments during your first year of retirement and adjust your annual withdrawals for inflation every year after that. Historically, your money should last 30 years or more. In reality, you may want to adjust this formula and build in flexibility to make it work best for you. Here's more about the 4% rule, its potential pitfalls and how to know if it can work for you.
How the 4% Rule Works
The 4% rule is a guideline for keeping your income consistent in retirement without depleting your retirement funds too early. The 4% rule has you withdraw 4% of your total investment portfolio in your first year of retirement, then adjust your payout for inflation in each subsequent year. If you retired in 2021 with $1 million in investments, for instance, your 2021 payout would be $40,000. Using the 2022 cost-of-living adjustment for Social Security—5.9%—your 2022 payout would adjust to $42,360.
The 4% rule came out of a 1994 research paper by financial planner William Bengen. Bengen found that hypothetical portfolios invested 50% in stocks and 50% in bonds lasted at least 30 years when they followed the 4% rule. He tested his portfolios in various 30-year periods beginning in 1926. Through good economic cycles and bad, market crashes and boom times, the 4% rule made it possible for hypothetical retirees to enjoy 30 years of consistent retirement income without going broke.
Over the years, many financial planners—including Bengen himself—have offered tweaks to the 4% formula. For years, 5% was a common recommendation. In late 2021, investment firm Morningstar released a report recommending a more conservative baseline of 3.3%, based on what they believe will be more modest returns on stocks and bonds in the decades to come.
Risks of the 4% Rule
The 4% rule remains a useful guideline for retirement planning. It does have limitations, however. If you're using the 4% rule to map out a retirement strategy, be aware of these potential pitfalls:
Your Money May Not Grow Fast Enough
Retirees who choose a more conservative investment portfolio might not see the same returns as the 50/50 split model used in Bergen's original calculations. Morningstar's report also points out that historic growth in the markets over the past few decades may not continue in the years to come. Low starting bond yields and high stock valuations may stand in the way of sustainable growth in the current markets.
You May Over- or Under-Spend
Morningstar suggests using a conservative 3.3% as a baseline for retirement drawdowns, while other investment strategists have suggested 5% or more. That's a significant range. Life expectancy, the economy and the stock market are all unpredictable—especially over decades. Building in the ability to adjust your withdrawals over the years can help prevent spending too quickly or scrimping unnecessarily.
Market Fluctuations Put Your Money at Risk
Look no further than the 2022 market downturn. The S&P 500 dropped nearly 21% in the first six months of 2022. Although markets have historically recovered over time, major fluctuations can affect your portfolio's long-term health. You may want to adjust your spending temporarily in response to market fluctuations. If you plan to retire soon, you may want to rebalance your portfolio to investments with less risk.
You Don't Account for Taxes
Money withdrawn from a traditional IRA is subject to regular income taxes. Money taken out of a regular investment account may be subject to capital gains taxes. State taxes may also come into play. These taxes come out of the money you withdraw, so you need to plan accordingly.
Emergency and Medical Spending Take a Toll
Even in retirement, unexpected expenses are always a possibility. Medical expenses, including long-term care, can be overwhelming: A 2022 report from Fidelity Investments found that the average couple retiring at age 65 will spend $315,000 for medical expenses in retirement.
You'll Outlive Your Money
Even though the 4% rule is meant to preserve your resources for at least 30 years, unexpected spending, major shifts in the stock and bond markets, economic swings and your own longevity could cause your money to run out prematurely. In these cases, it's not so much that the 4% rule causes a shortfall; rather, it's that it can't protect your money from every possible scenario.
Should You Follow the 4% Rule?
The best advice may be to use the 4% rule as a starting point, not a rigid guideline or a substitute for active planning. To understand how the 4% rule might apply to you, do a quick estimate of where your retirement savings might be when you retire. Now ask the following questions:
Is 4% a Realistic Starting Point?
Suppose you have $250,000 in retirement savings and you want to retire now. Will $10,000 per year, or $833 monthly, be enough to sustain you—bearing in mind that Social Security, pension and annuity income will also be a factor?
How Long Do You Need Your Money to Last?
The 4% rule is designed to maintain your assets for at least 30 years. The average 65-year-old in the U.S. can expect to live 18 to 21 years, and many people live well into their 90s and beyond. While most people can't predict how long they'll live with accuracy, you can factor in your age at retirement, overall health and family history of longevity to get a ballpark estimate. Retiring at 55? You may need more than 30 years of funding. Finally slowing down at 73? You may be able to spend a little more.
How Flexible Can You Be?
While the idea of steady retirement income is appealing, retirement spending isn't always steady. Younger retirees may be more inclined to travel and spend on activities like dining out. On the other hand, older retirees may incur higher medical or long-term care expenses.
Economic and market factors can also affect your portfolio. In a down market, are you willing to withdraw less or forgo cost-of-living increases to help preserve your money?
Do You Have a Backup Plan?
What happens if you incur large expenses that don't fit into your regular budget? Do you have adequate resources to cover major expenses? What happens if you outlive your savings? Can you survive on Social Security? Can you sell assets, such as your home? Do you have family members who can help you bridge the gap?
The Bottom Line
The 4% rule can be a helpful starting point for planning your retirement. But your individual needs may vary, and 30 years of retirement is too long for a set-it-and-forget-it strategy. You'll need to preserve your money and meet three decades of sometimes unpredictable financial obligations, which will probably require making adjustments over time.
To put yourself on the right track, consider finding a financial planner who can help you map out a retirement strategy, then keep you on target with regular check-ins as you navigate your retirement years. The 4% rule is a good place to start your thinking but it's not the only strategy you'll need to manage a long retirement.