Here’s an example of how a withdrawal rate works:
Assume you have $400,000 in an investment account at the beginning of the year.Over the course of the year, you withdraw $16,000.Your withdrawal rate for the year is 4% ($16,000 divided by $400,000 and then multiplied by 100).
4% or 4.5%
Ever since financial planner Bill Bengen came up with the 4% rule, aka the Bengen rule, in 1994, many financial advisers have been recommending 4% as a safe annual withdrawal rate to ensure retirees’ money lasts for 30 years. In an interview with the American Association of Individual Investors’ AAII Journal from January 2018, Bengen said he’s now suggesting that an inflation-adjusted 4.5% annual withdrawal rate is safe. He recommended broader classes of investments than he was able to obtain data on for his 1994 Journal of Financial Planning article, which tracked the experiences of investors from 1926 to 1976. And he said high inflation is a bigger threat to having enough money for retirement than low investment returns, though he said a long bear market can also have a devastating effect on retirees.
Inflation Adjustment
Bengen suggested starting with the consumer price index (CPI), which can be used as a basis for calculating the annual rate of inflation, to determine your own personal inflation rate. Let’s say you saw an increase in medical costs in the previous year that was higher than expected based on inflation. You would want to increase your inflation rate a bit to account for that and so arrive at a personal inflation rate of 4.2%. Bengen says you should apply that rate to the amount you withdrew last year to determine what you should withdraw this year. Let’s use the previous example of withdrawing $16,000 from an account containing $400,000. Multiply 0.042 times $16,000 to arrive at $672. Add that figure to $16,000 to come up with $16,672 for your in-service withdrawal amount for this year. If your personal inflation rate goes down a bit this year to 3.8%, you would multiply 0.038 times $16,672 and add the result ($634) to $16,672 to arrive at next year’s withdrawal amount of $17,306.
Taxes and RMDs
Bengen’s rule does not take taxes into consideration. All withdrawals except those from a Roth IRA, which was funded with after-tax dollars, will be subject to federal income tax. You should calculate how big your annual tax payment will be and keep that in mind when determining how much to withdraw. Once you reach the age of 70 1/2, the Internal Revenue Service requires you to begin making withdrawals from your retirement accounts, again with the exception of a Roth IRA, because the IRS has already gotten its cut of the money you invested there. These required minimum distributions (RMDs) are determined based on a factor the IRS arrived at that’s based on your life expectancy.
Yearly Updates
It’s important to monitor your withdrawal rate, your remaining amounts of money, and your spending each year. You need to make sure your spending is at a healthy, sustainable rate when compared with the size of your investment portfolio and other retirement savings accounts. If your portfolio had a bad year, you might want to lower your withdrawal rate and decrease spending. In a great year, you could increase your withdrawal rate and reward yourself with a nice trip to a new locale.
A Couple of Useful Approaches
One way to make sure you don’t withdraw too much is to set up a systematic withdrawal plan that directly deposits a set amount of money from your investments into your checking account. These regular withdrawals serve as paychecks, and if you spend only what you’re “paid,” you won’t go through money that was earmarked for a future year. Another approach that’s been successful for some retirees is to invest using a time-segmented system in which your investments are made to match the time frame of when you will need them. For example, a certificate of deposit (CD) may mature each year to meet your spending needs for that year.
