Your Money

Ditch the 4 percent rule. Here's how to handle your retirement withdrawals

Key Points
  • Many investors withdraw 4 percent each year from their retirement portfolios, adjusted annually for inflation, and hope that their nest eggs don't run out.
  • The 4 percent rule may be unsafe if a portfolio takes losses in the early years of retirement.
  • Build your customized withdrawal rate by considering your life expectancy, Social Security benefits and tax situation.

So you have amassed a nest egg large enough to retire. Now comes the hard part: figuring out how much you should withdraw each year to enjoy life and make sure you don't run out of money.

It can be a difficult balance. Many investors simply use the 4 percent rule. Under this scenario, you withdraw 4 percent per year from a diversified portfolio of stocks and bonds, adjusting annually for inflation, and you will have enough to last for 30 years in retirement, based on historical returns of the U.S. stock market.

The problem with the 4 percent rule, which was developed in the 1990s, is that portfolio losses in the early years of retirement would make following it unsafe for many retirees, according to research by Wade Pfau, a professor of retirement income at the American College of Financial Services.

Top retirement myths
Top retirement myths

Studies have shown that retirees are actually more frugal than the 4 percent rule would indicate. They leave behind a similar amount of wealth regardless of what age they die, and older people become steadily more pessimistic about their own future economic prospects.

Some financial advisors recommend people scrap the 4 percent rule altogether.

"We don't use safe withdrawal rates — ever," said Craig Larsen, a certified financial planner and founder of AHC Advisors in St. Charles, Illinois. "We feel that this deprives those in their earlier retirement years of life experiences, and those individuals don't get a second chance at their early retirement years.

"Instead we build a financial plan that helps them achieve their spending goals, and update it every year," he added.

When building your own plan for retirement income, there are three things to consider.

Life expectancy

What makes finding the right level of retirement income each year so difficult is that you don't know how long you will live.

The Social Security Administration estimates that a man reaching age 65 today can expect to live on average until age 84 and the average 65-year-old woman would live until age 87. Roughly one out of every four 65-year-olds today will live past age 90 and 10 percent will live past age 95.

But those are simply averages. "And in reality, someone who has a family history of long lives can herself have a short life," said Barry Kozak, an estate lawyer at October Three Consulting in Chicago. "No one can ever plan on life expectancy, and should always overestimate how long they will live."

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Social Security benefits

Working longer to maximize your Social Security benefits is the lowest-cost path to guaranteed income you can find in retirement. "Social Security benefits do have a cost-of-living adjustment, so at least that source keeps up with inflation," Kozak said.

The average monthly Social Security benefit right now is $1,360, while the maximum monthly payout for someone who is age 70 and has worked for at least 35 years is $3,538 in 2017.

Social Security benefits grow roughly 8 percent for every year you delay past age 62, the earliest year you can claim. However, most people file for benefits before they reach their full retirement age, or the age at which their benefits aren't reduced. (See table below.)


Drawing down retirement assets can be more difficult than building your nest egg because taxes are trickier.

Your tax liability depends on your retirement accounts. Any withdrawals you make from your traditional individual retirement accounts and 401(k) plans are taxed as ordinary income, while the money you pull out from your Roth accounts is tax-free.

Watch out for required minimum distributions for traditional IRAs and workplace retirement plans. If you don't make the appropriate withdrawals, you may have to pay a 50 percent tax on the amount that was not taken out as required.

Generally, you have to start taking withdrawals from your traditional IRA, SIMPLE IRA, SEP IRA or retirement plan accounts when you reach age 70½. If you are still working, some 401(k) plans allow you to defer RMDs from those plans until you retire. (See chart below.)

"Traditional thinking is to wait until 70½ to start taking IRA and qualified plan distributions and then take the RMD," said Todd Minear, a CFP and founder of Open Road Wealth Management in Kansas City, Missouri. "However, for many retirees, it could make sense to begin these taxable distributions earlier than that, making future distributions smaller."

The goal should be to manage distributions from all your taxable, tax-deferred and Roth accounts in a way keep you in the lowest tax bracket as possible. "One of the biggest mistakes people make when drawing down for retirement is not being tax-efficient," Minear said.