The Four Percent Rule

[medved]

When people talk about being able to "safely" withdraw 4% of their invested assets each year (putting aside the many issues with this "rule" and the benefits of flexibility in post-retirement spending), they're talking about the 4% covering taxes as well as living expenses, right? And this includes capital gains taxes, correct? If so, isn't this "rule" somewhat useless because each person's tax basis in their investment assets will differ -- dramatically -- and so will the capital gains tax they need to pay when they're liquidating assets in retirement? How does capital gains tax play into the four percent rule?

Is the answer simply that, as a rough general guideline, based on historical results, a retiree can safely withdraw 4% of her investment portfolio each year, and if she has substantial capital gains then she will just have to pay a bigger chunk of that 4% withdrawal to the government that someone who does not have capital gain? So each of these people - the one with big capital gains in the one with no capital gains - can still withdraw 4%, but one of these people will have a lot less than 4% to live on, while the other will have most or all of her 4% to live on?

 

[nvestysly]

You bring up some interesting questions. I'm sure there are some on this forum who will have some very good, probably very specific, responses.

For DW and I the tax issue has very little impact. For a variety of reasons we typically pay ZERO federal income tax and very little state income tax. We are very careful to limit capital gains to reasonable amounts. We live on a modest amount of money so no need to withdraw huge amounts - ours is approx. 3%. With charitable contributions, property taxes, and other tax deductions the tax implications for us are nearly negligible.

 

[samclem]

Is the answer simply that, as a rough general guideline, based on historical results, a retiree can safely withdraw 4% of her investment portfolio each year, and if she has substantial capital gains then she will just have to pay a bigger chunk of that 4% withdrawal to the government that someone who does not have capital gain?

Yes.
And the most often cited version of the 4% rule allows for a 4% withdrawal of the initial portfolio value, followed by inflation adjustments of that amount every year (so, the withdrawals are relatively constant from year to year). Another version that many people use (and what you've described above) is to take 4% of the portfolio's ending balance each year. And there are plenty of other permutations (you can easily model them in FIRECalc). But none of the common ones attempt to correct for tax rates, loads on funds, amounts paid to financial advisors, etc. All of that must come out of the annual withdrawal amount.

 

[REWahoo]

The 4% rule does not address taxes.

It is simply the initial % you can safely withdraw from your nest egg, then adjust the withdrawal annually for inflation, and have a 95% chance of not depleting your nest egg for 30 years.

 

[HFWR]

Folks like me, with primarily tax-deferred accounts, get taxed at regular income rates, so the cap gains in a taxable account might be the better deal, tax-wise, in some cases.

 

[daylatedollarshort]

I use a spreadsheet with year by year expenses, income, net worth, taxes and related figures for retirement planning. I put in real returns and inflation as parameters and model different scenarios. The I use the Fidelity Retirement Planner for a second opinion and reasonableness check.

 

[pb4uski]

I wouldn't say it is useless... you can withdraw 4%... pay the relevant taxes and you can spend the rest. No problem. Taxes in retirement will often be fairly modest. Mine would be nil absent Roth conversions.... even with Roth conversions it is ~10%. No big deal.

 

[Sunset]

My view on the 4% rule is that is the amount you can withdraw, what you spend it on is up to you.
If you live in a tax free environment or a high tax environment it's still the same 4% amount.
For example if all your investments were in a Roth, it would still be 4%

 

[NW-Bound]

The 4% rule is definitely not useless.

You start with the 4% WR pretax. Everybody's tax is different, but you should know what yours is. Pay the tax, then the rest is yours.

Of course, it makes a big difference whether your WR is from an IRA, an after-tax account, or a Roth account. And most people have a mixture of these types of accounts, so their tax will vary through their retirement depending on what accounts they draw from that year.

ORP is a calculator (search the Web for it) that lets you see how to optimize the withdrawal to minimize the tax though your retirement.

 

[FIRE'd@51]

It is simply the initial % you can safely withdraw from your nest egg, then adjust the withdrawal annually for inflation, and have a 95% chance of not depleting your nest egg for 30 years.

Technically, Firecalc says that historically you would have not run out of money 95% of the time. This is not the actual probability going forward, because overlapping data reduces the number of independent data points such that the 95% is not a statistically significant ex-ante probability.

 

[mathjak107]

taxes are an expense , like any other expenses we have . all our expenses differ and all our taxes differ .

you treat taxes no different than any other expense .

when you were working your gross income was without taxes wasn"t it ?

how and what you allocated your gross income to while working is no different than how to allocate the gross income the 4% swr gives you . you still need to allocate your fair share of taxes just as you always did from a gross income .

you should be ball parking taxes and entering them as the expense they are .

 

[DrRoy]

Technically, Firecalc says that historically you would have not run out of money 95% of the time. This is not the actual probability going forward.

The calculations that Firecalc runs use actual historical returns for the probabilities that are the result. If future returns are lower than the ones in the calcualtion (which is what I believe), then the result will be too optimistic.

 

[marko]

But let's all remember that the 4% "rule" is a guideline, not set as an actual fact.

Your investment profile, what you're invested in and unforeseen market actions play a part in whether 3%, 4% or 2% will actually have you with $ in 30 years.

I personally tend to follow the 4% guideline but if you keep your money under a mattress or low paying CDs instead of being properly invested, you'll certainly be in trouble if you plan to spend 4% each year.

 

[NW-Bound]

Yes. I look at the 4% as a guideline.

A few years back, I was wondering what kind of withdrawal I could get. Would it be as high as 8% as I read about what some pension funds were using? Then, Web surfing found me FIRECalc and this forum. Definitely not 8%!

 

[Turn_the_Page]

The study that was done "proved" (or argued) that 4% initial WD, inflation adjusted each year would not exhaust the portfolio in a reasonable length retirement. If you WD more than 4% to cover taxes, then you are not at a 4% WD and you're assuming a higher risk of portfolio depletion.

It's not perfect and there are MANY other accepted means to determine safe WD rates. It is a good starting tool. I've used it many times in conversations with co-workers thinking about retirement that have done virtually zero reading or studying on the subject.

 

[donheff]

I prefer an analysis that focuses on gross income because I can then add in my specific tax situation and figure out what I will have left to spend. Any calculator that tries to incorporate taxes is going to be very limited going forward. Tax rates change. I would rather rely on my own guesstimate about where taxes will go that base my retirement on someone else's.

 

[medved]

Thanks for all the responses. They confirm what I thought and that having a tax-efficient withdrawal strategy is important. Regarding whether the 4% "rule" will give a 95% chance of not running out of money, who knows. The future might be better than the past, or worse. I suspect it comes down to how risk-averse one is. I am very risk averse, so I will try to limit my withdrawals to 2% per year (in the first year, plus an inflation factor), or something like that. Maybe that will result in my dying with a big pot of cash, which will benefit some charities and my kids. That is not really my objective; just a byproduct of being risk averse. But the 4% rule does show me that, if I want to splurge in a couple of years, I probably can.

 

[NW-Bound]

At 2% WR, you are golden because that's the current S&P 500 dividend rate.

 

[samclem]

I am very risk averse, so I will try to limit my withdrawals to 2% per year (in the first year, plus an inflation factor), or something like that. Maybe that will result in my dying with a big pot of cash, which will benefit some charities and my kids. That is not really my objective; just a byproduct of being risk averse. But the 4% rule does show me that, if I want to splurge in a couple of years, I probably can.

If you can handle variability in your annual withdrawals, you may want to consider basing your withdrawals on a percentage of your portfolio's year-end value, rather than just taking an amount now and adjusting it for inflation. Advantages:
1) You can never entirely run out of money. You take a "hit" on the real value of your withdrawals over time (if the portfolio doesn't have after-inflation gains), but there won't be a sudden "I'm now broke."
2) This method lets you spend more if your portfolio does well (so you decrease the chances of having a huge pile of money at the end), but you'll also need to spend less if your portfolio takes a hit. Since that's something I'd probably do anyway, it makes sense for m to just make it a part of my plan.

Bob Clyatt's "95% rule" provides a way to smooth out the variability of the annual withdrawals while preserving most of the advantages of a portfolio-linked annual withdrawal method. See his book and the the posts here. FIRECalc will also model that for you, it has a dedicated function to do it.

Good luck!

 

[HFWR]

Have only started the FIRE journey, thus only one withdrawal so far (4%). I plan to follow the method samclem mentioned, i.e. 4% of porfolio value, with no inflation adjustment. The equity portion of a portfolio is there to provide growth, and inflation protection. So that's my inflation adjustment. YMMV, plus it's not chiseled in stone, and can be changed...

 

[OverThinkMuch]

A better name is "the 4% guideline". If you look at $200,000 in retirement and expect to withdraw 20% / year, the 4% rule should warn you you're far off the mark. Or if you can live on 2% of assets, that you're probably safe. When you look too closely at the 4% guideline / rule, it's time to get out calculators and factor in your specific circumstances. And that's why I'd say a guideline - it considers nothing about your assets, account types or taxes.

For example, a proposal in Congress to end Roth Conversions cited some tricky people who put millions into Roth IRAs (insider stock options, which rocketed up in value). If you have millions in a Roth IRA, 4% withdrawals will cost you 0% in taxes. If you have a cost basis in a taxable account, you pay a reduced tax rate on the long-term gains. And if you have a Traditional IRA, you're paying ordinary income tax rates regardless of how long you had the assets. So even the tax rate varies by account type, which I think emphasizes the 4% "rule" as more of a guideline and starting point, before digging into specific circumstances.

 

[mpeirce]

Have only started the FIRE journey, thus only one withdrawal so far (4%). I plan to follow the method samclem mentioned, i.e. 4% of porfolio value, with no inflation adjustment..

This is our approach. We use a three year trailing average which smooths out big up or down years.

You have to be more comfortable with variation if you use this and have a budget that can accommodate it. We put most of any increase into our travel budget which will be easier to cut when the inevitable down years arrive.

 

[ERD50]

... Regarding whether the 4% "rule" will give a 95% chance of not running out of money, who knows. The future might be better than the past, or worse. ...

Agreed, but just to put a finer point on that - it isn't so important whether the future is better/worse than the past for the 4/95 guideline to hold. What is important is whether the worst of the future is worse than the worst of the past.

For example, the average inflation adjusted returns of the future might be slightly better than the past, but if there are a few really bad cycles in there, it could wipe someone out.

Conversely, the average inflation adjusted returns of the future might be worse than the past, but if there is a tighter distribution, then maybe no cycles were worse than the past. There is a very wide spread in the final portfolio values you see on a 30 year FIRECalc run, some of those might be considered outliers?

Regardless, a 2% WR is very conservative, and even if things get really really bad, you will be better off than the vast majority of people. Now go and enjoy life!


-ERD50

 

[Which Roger]

The calculations that Firecalc runs use actual historical returns for the probabilities that are the result. If future returns are lower than the ones in the calcualtion (which is what I believe), then the result will be too optimistic.

Unless the lower returns are accompanied by less volatility. What kills a portfolio is a bad sequence of returns during the first few years of retirement. With less volatility, there is less of a chance of this happening.

 

[audreyh1]

When people talk about being able to "safely" withdraw 4% of their invested assets each year (putting aside the many issues with this "rule" and the benefits of flexibility in post-retirement spending), they're talking about the 4% covering taxes as well as living expenses, right? And this includes capital gains taxes, correct? If so, isn't this "rule" somewhat useless because each person's tax basis in their investment assets will differ -- dramatically -- and so will the capital gains tax they need to pay when they're liquidating assets in retirement? How does capital gains tax play into the four percent rule?

Is the answer simply that, as a rough general guideline, based on historical results, a retiree can safely withdraw 4% of her investment portfolio each year, and if she has substantial capital gains then she will just have to pay a bigger chunk of that 4% withdrawal to the government that someone who does not have capital gain? So each of these people - the one with big capital gains in the one with no capital gains - can still withdraw 4%, but one of these people will have a lot less than 4% to live on, while the other will have most or all of her 4% to live on?

You have to cover taxes out of that withdrawal. So as part of retirement planning, you need to estimate your taxes in retirement, and have enough of a nest egg to cover expected taxes as well as spending needs.

Fortunately, capital gains taxes are equal to or lower than ordinary income taxes, and there is even a chunk that is subject to 0% taxes if your total income is below around $75K.

And, capital gains are on the difference between sold and bought price, so you might be paying 0 to 15% on a much smaller amount that the total proceeds you receive when you sell. It depends on how much of the sales proceeds are the gain.

People withdrawing from IRAs pay ordinary income taxes on the withdrawal, so they might be worse off than someone paying capital gains taxes depending on the specific scenarios of course.

The rule is perfectly useful as it is independent of any person's tax scenario. You just have to do the work to figure out your tax situation.

Many people find their Federal income taxes drop significantly when they retire and are no longer earning wages.