Withdrawal Rate for Your Retirement Paycheck
Updated: Feb 17
You spend your working years accumulating wealth through saving and making regular investments to fund your future goals – retirement plans, second homes, and dreams for the next generations of your family. Each of your goals is unique to your aspirations and vision for the future.
Once you move into retirement, your new paycheck is based solely on how your investments work for you. And as you move closer to your retirement milestone, it is understandable you may wonder whether you have ‘enough’.
So as part of Peak Wealth Planning’s financial education mission, I’d like you to gain an understanding of withdrawal rates on your retirement savings.
Once you have an estimate of your accumulated wealth or nest egg, it is important to consider your safe annual withdrawal rate. That is the percentage of your nest egg you could withdraw every year without running out of money before you die.
An appropriate withdrawal rate coupled with good market returns may prevent you from running out of money.
The 4% Rule
In 1994, financial planner Bill Bengen came up with the 4% rule, which has since been commonly recommended as a safe annual rate of withdrawal. This doesn’t guarantee that you won’t run out of money, but if your portfolio has the right blend of stocks, bonds, and real estate, and the markets perform well, there is a reasonable chance that you could spend 3 to 4% of your nest egg each year and keep pace with inflation. In recent years, since bond yields are quite low, many financial planners have reduced their recommended safe withdrawal rate to the 3% to 3.5% range.
Your Withdrawal Rate
To compute your withdrawal rate consider the total value of your investment accounts and how much income you need to support your lifestyle.
Here's an example of how to calculate your withdrawal rate:
Review Investments: Assume you have $3 million in an investment account at the beginning of the year.
Clarify Budget: Over the course of the year, you withdraw $10,000 each month.
Identify Annual Withdraw Rate: Your withdrawal rate for the year is 4 percent ($120,000 divided by $3 million and then multiplied by 100).
The average annual return on your retirement nest egg should exceed your withdrawal rate in order to not run out of money before you die. When the average annual return exceeds the withdrawal rate, you should have a cushion of funds (safety net) near the end of your life for long-term care or to pass on to your heirs.
Fund Your Retirement Paycheck
One way to make sure you don't withdraw too much is to set up a direct deposit each month to move 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 cash bucket in which your investments are made to match the time frame of when you will need them. For example, you may want to keep three years of cash in low-risk bonds or money market funds for spending at the beginning of your retirement.
What about inflation?
Continuing our $3 million nest egg example, if your investments earn 8% during the year, then you would have $3.1 million in your account after withdrawing $120,000. The next year, instead of withdrawing $120,000, you might withdraw $124,000 providing yourself a 2.5% raise to account for inflation. One option to consider as a benchmark for inflation is the Consumer Price Index or CPI.
Be careful not to increase your annual withdrawals too dramatically, this could lead to spending down your nest egg too aggressively. If you spend too aggressively, you could run out of money before you die.
Taxes and RMDs
Bengen's 4 percent rule does not take taxes into consideration. Most retirement withdrawals from 401ks and IRAs except those from a Roth account, which was funded with after-tax dollars, will be subject to federal and state income tax. You should calculate how big your annual tax payment will be and keep that in mind when determining how much to withdraw. Many retirement accounts will allow you to direct a portion of your withdrawals to federal and state taxes. That way, what winds up in your checking account is after-tax money.
Once you reach age 72, the Internal Revenue Service requires you to begin making withdrawals from your tax-deferred retirement accounts. These required minimum distributions (RMDs) are determined based on a factor the IRS arrived at that's based on your life expectancy.
It's important to monitor your withdrawal rate, your remaining nest egg, and your spending each year. You need to make sure your spending is at a healthy, sustainable rate when compared with the average annual return and the size of your investment portfolio. Your average annual return should generally exceed your computed withdrawal rate.
If your portfolio suffered more than three bad years in a row, you might want to lower your withdrawal rate and decrease spending. Or, if stocks have a great year, you could sell some stocks and rebalance into lower-risk bonds and cash to refill your cash bucket.
Creating a safe annual withdrawal rate unique to your individual asset allocation, retirement spending needs, and tax bracket can bring you peace of mind that you can live comfortably for many years. Your financial advisor can help determine a safe withdrawal rate that will work well for your unique situation. And, he can help you invest your nest egg to make sure you do not run out of money.
Are you planning for retirement? Have you calculated your safe withdrawal rate and how much you can spend during retirement? If you have a net worth over $2 million and need help from a wealth manager, the Peak Wealth Planning team can assist you.
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About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance, and estate planning advice. Peak Wealth Planning is a fee-based financial advisor based in Champaign, Illinois, and Fraser, Colorado.