It’s no simple task to accurately calculate your retirement income needs all on your own.
Sure, there are people who endorse something called the 4% Rule. But that one-size-fits-all approach neglects a lot of important variables, making it, at best, a so-so guideline for some retirees, but completely useless for others.
Briefly, the rule states that an annual withdrawal from your savings in the amount of 4% is probably sustainable because you can have a reasonable expectation of earning a 4% annual return from a well-diversified, moderate-risk portfolio.
Simply, 4% deducted from savings as income is balanced by a 4% return on investments, so you (ideally) have no depletion of principal.
I’m a big advocate of living off your income and not your principal, but I’m also here to tell you that the 4% Rule has serious limitations. That’s because balancing future tax considerations, large retirement account balances, inflation, market swings, and unexpected expenses means that, in most instances, a fluid, proactive approach to calculating your retirement income needs is essential.
Here are some things to consider that impact the long-term viability of the 4% Rule.
Do not automatically defer your retirement account distributions until age 70½.
With a few exceptions, such as older 401(k)s that include “after-tax” dollars, distributions from retirement accounts are taxed as ordinary income. I’ve known a lot of conscientious savers who guard the sanctity of their retirement accounts (401(k), 457, 403b, IRA) with a vengeance.
Simply, they started saving inside those accounts early in their careers, the balances are still growing, and they don’t want to tap into that money until they’re absolutely forced to at age 70½.
For some people, however, it actually makes good financial sense to start dipping into those accounts well before the IRS demands you take required minimum distributions (RMDs).
Problems arise when the balances in your retirement accounts are large (and you’ve waited until age 70½), and those sizeable RMDs actually shove you up into a higher tax bracket (I’ve seen this many times).
This can needlessly cost you thousands of extra dollars in taxes.
The 4% Rule doesn’t take into consideration the tax nuances of people who are delaying tapping into their retirement accounts until later.
Even if you can afford it, don’t automatically defer applying for Social Security until age 70.
Not only did Social Security used to be a lot easier to understand, for “good savers” I think it’s actually going to become even more difficult to navigate in the future.
But, first, when should you apply?
It takes planning and numerous calculations to determine the best course of action for each individual.
All are important factors that must be considered before you apply for benefits.
Remember, once your income reaches a certain threshold, your across-the-board tax rates increase. And if you wait until age 70 to apply, you’ll be combining your Social Security income with your RMDs (and any other income) and paying all the more to your state and federal governments.
I believe that big changes are coming to Social Security. Waiting to apply (until age 70) might actually be a mistake. That’s because good savers may (due to “means testing”) find themselves either shut out entirely, or perhaps receiving a smaller monthly benefit (and at a higher tax rate) than they would’ve if they’d applied earlier.
Again, the 4% Rule isn’t nuanced enough to account for Social Security income. And while you may be fortunate enough (and may have saved well enough) to see Social Security as merely a “bonus,” you still want to integrate it in such a way as to maximize your income while minimizing your tax burden.
There are certainly other scenarios where a strict adherence to the 4% Rule doesn’t add up to a good fit for retirees. For instance, people with an ultra-high investment risk tolerance need to be more conservative with their use of retirement money because their portfolios tend to be more volatile. A market downturn combined with a 4% rate of withdrawal could derail decades of hard work in a very short amount of time.
Lastly, anyone who elects to embrace the 4% Rule needs to stay married to it forever. That’s because if you have a major, unexpected expense (or you lose discipline and splurge), and in just a single year you not only spend your 4%, you also gobble up an additional 6% of your principal, as well, from that year forward you’re going to have less principal to earn compounding interest (income).
And, once out of balance, while you may not notice it this year, the financial repercussions five or 10 years from now could very well be impossible to overcome.
For more information about the 4% Rule, retirement account distributions, or how you can create a plan that helps you retire better, contact us today.