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Fail: Not knowing what the 4% rule is.
Flip: Understanding the 4% rule and now having a target number for retirement.
When thinking about retirement, you can’t help but ask, “How much do I need to save for retirement?” You want to have enough to do everything you want to do, but you don’t want to put yourself into a position where you run out of money and need to return to the workforce in your 70s. What is that magical number?
What is the 4% Rule
Bill Bengen, a financial planner, developed the 4% rule and has published multiple articles about his work. This has become a rule of thumb used today by many financial experts. Basically, what it says is that you can draw 4% of your retirement portfolio every year, adjusting for inflation, and you won’t run out of money for 30 years.
To estimate how much you will need to withdraw from your portfolio, you need to really understand what expenses you might have. Do you plan to have a mortgage? What would your health insurance costs be? (This one is a biggie and has been the hardest to predict for everyone.) Will you be supporting any adult children? This is in addition to the cost of your utilities, property taxes, and normal monthly bills.
Be considerate of what you might be doing with your extra time. Will you be travelling or picking up new hobbies? Will these endeavors add an extra cost? I know for us we are dreaming of traveling the United States in an RV, so that means we need to consider first the cost of purchasing the RV, and then gas, parking fees, and other travel expenses.
Currently, with two kids in the house and our mortgage, our monthly expenses are $5000 on average. This does not include any money that we put into investments since once retired, we would no longer be contributing. We then take our monthly expenses times 12 months to get our yearly expense.
$5000 X 12 months = $60,000
To determine the 4% rule we could divide our yearly expense by 0.04 (4%) or multiply our yearly expense by 25.
$60,000 /0.04 = $1,500,000.
$60,000 * 25 = $1,500,000
I would need $1,500,000 in my investment accounts to pull $60,000 a year.
Now comes the complicated part. Is this all pretax? If so, I have to add in enough to cover taxes, which will be about 25-30% based on the 2018 federal and tax brackets for married filling jointly, I would have to make approximately 11,000 more.
$71,000/0.04 = $1,775,000
Other Factors to Consider
Here is a list of other things you may need to consider in your calculations.
- After tax assets such as Roth IRAs
- Social Security
- Inheritance – don’t always rely on this, but it depends on each individual. I choose not to include this in any of my calculations.
- Mortgage – Will it be paid off when you retire?
- Other Income streams in Retirement – Rental, Other W-2 employment, passive side income, etc.
- Health Care
- Other large expenses
A More Complex Scenario
Here is my scenario, with some of the other factors taken into consideration. I will be able to collect a pension starting at the age of 55, which should bring in approximately $36,000. This amount would be much larger if I chose to wait to collect until I was 65, but I am hoping to retire early, so I am choosing to use this number at this time. We do have a rental property with a mortgage and we currently still have a primary mortgage. I have set goals to have both of these mortgages paid off by retirement, so our rental should bring in about $12,000 profit every year. Most of our money is in pretax accounts at this time, so I will also calculate in taxes.
Here is what it looks like so far.
$36,000 – Pension
$12,000 – Rental Income
My Range of Proposed Expenses including travel, lifestyle, etc. $60,000 – $75,000
Before Taxes Need $78,000 – $97,500
Before Tax Amounts subtracting the $48,000 from Pension and Rental Income – $30,000 – $49,500
Take that range *25 = $750,000 – $1,237,500
This is my target range for retirement planning.
My Long Term Financial Goals
- Pay off my mortgages
- Save enough to have in the range of $1,000,000 – $1,250,000 in retirement.
Don’t get overwhelmed
Each scenario is based on your individual needs. If you take steps now to decrease your spending and payoff debt, it is very likely you would need much less money. You also may have a longer timeframe until retirement where your money can continue to compound. This is also just my starting number. As I continue in my process, I continue to see this number fluctuate based on the decisions I am making today. It is highly probable that I would need less than this when I retire. You just need to focus on you and your family to determine what could be your target number.
Why Not the 4% Rule?
If you dig into the 4% Rule, you may find some controversy around it. For instance, it is only meant as a rule if you have a 30 year retirement. With many people, living longer, it may not hold. Some have then started taking a more conservative approach with a 3% or 3.5% rule.
The point, is that you need to start with a goal, and the 4% rule gives a number to reach for. From there, you can work backwards to know what you need to start saving every month to reach that goal.
Whether you go with the 4% rule or you work with a financial advisor that uses another formula to help you determine your retirement number, just have something. Have a goal and start working towards that goal. That is how you can start planning for retirement and be on the path to financial independence.