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What is the 4% rule and how can it help you save for retirement?

According to wealth manager Scott Meyer, this simple rule can be a good way to start thinking about your retirement goals.

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Saving for retirement can seem daunting, especially when you have no idea where to start. But the 4% rule, a popular guideline used to determine how much you can comfortably spend each year from your retirement savings, can actually provide some clues for how much money you'll need to retire and what you need to do to get there.

"The definition of the word 'retire' is actually 'to remove yourself from a situation,' but in reality, retiring is actually starting a new chapter of your life," says Scott Meyer, a wealth manager and partner at Merit Financial Advisors. "It's not about leaving the workforce; it's about starting a new chapter, and it's important to think about what that new chapter will look like and how you can put a monetary value behind it."

According to Meyer, the 4% rule is a great place to start thinking about our retirement savings. Here's what you need to know.

What is the 4% rule?

The 4% rule states that you should be able to comfortably live off of 4% of your money in investments in your first year of retirement, then slightly increase or decrease that amount to account for inflation each subsequent year. Based on historical data, living off of just 4% will allow you to use your retirement portfolio to cover expenses for 30 years.

"The 4% rule first became popular in the mid-'90s," Meyer says. [Research] "found that if you withdrew 4% each year in retirement, there would actually be a high probability that your money would outlast you in retirement."

Recently, some financial planners have re-evaluated the 4% practice due to the possibility of lower Social Security distributions in the future and the concern that retirees will need to make their savings last a little longer. As a result, many financial planners now believe that 3.3% may be a more comfortable amount to withdraw each year.

"Because the 4% rule is so popular, it has been challenged for decades because it's such a widely used measure that people want to make sure it's still accurate and relevant," Meyer says. "The argument for why that number should be higher or lower depends on the environment you're in, the environment of the future market and the future economy. How long we live also has a big impact on how much we'll need. As a result, there are arguments that we should be withdrawing less each year because we're living longer and will need more money."

The 4% rule and the updated 3.3% rule are actually rules of thumb for how you should spend money in retirement, not explicitly how to save for it. However, having an idea of how much money you're going to spend in your non-working years can help you work backwards to figure out how much you'll need to have saved up in the first place.

How do you work backwards using the 4% rule?

"There is a quote that says you should 'begin with the end in mind,'" Meyer says. "So you should determine how much you're going to need to spend each year in retirement and use that 4% rule of thumb to figure out how much money you'll need to last you throughout retirement."

To figure out how much money you need to save before you can retire, you'll want to first estimate how much money you'll spend each year in retirement. To do this, you should consider the following costs as a jumping off point:

  • Rent or mortgage
  • Health care and long-term care costs
  • Annual cost of groceries
  • Annual cost of medication
  • Transportation costs (whether that's car payments and maintenance or public transportation expenses)
  • Amount you plan to spend on travel each year
  • Pet expenses

This is not an exhaustive list, as everyone's expenses will be different, especially when you consider what kind of lifestyle you want in retirement. But you can use the above spending categories as a way to begin thinking about some of the costs that will need to be covered in retirement. And one cost Meyer believes people shouldn't underestimate is health care.

"Most people are concerned about expenses regarding health care, so it's important to understand the premium costs and out-of-pocket costs of health care in retirement," Meyer explains. "And alongside this, people are concerned about long-term care costs for when they can no longer care for themselves. It can get very expensive if not managed right."

Once you add up all your potential costs per year, you might also want to account for some discretionary spending money for any other expenses that may pop up — this could mean tacking on an additional $5,000 to the total you just calculated. Let's say you estimate your potential annual spending will be $40,000; with an additional $5,000 as a cushion, you'll be spending about $45,000 a year in retirement.

Next, you should consider approximately how much of that money you'll be receiving through federal benefits like Social Security. The Social Security Administration has an online benefits calculator that lets you estimate how much you might receive in social security based on your income now and when you hope to retire.

Let's say you expect to receive around $20,000 a year through Social Security distributions. This means that instead of withdrawing $45,000 from your retirement savings each year, you'll only need the difference between $45,000 and $20,000, which will be $25,000.

Now that you know how much money will need to come out of your retirement savings each year, you can use the 4% rule to figure out the total amount you'll need to have saved up before you enter retirement. Simply take $25,000 and divide it by 0.04 to get $625,000. In other words, $625,000 will last you 30 years if you only withdraw $25,000 (4%) a year. And if you want to go by the updated 3.3% rule, you'd divide $25,000 by 0.033 to get $757,575.

How can you start saving now?

Knowing how much money you'll need to have saved up before you enter retirement can help give you an idea of how much you should be putting away right now in order to reach that goal.

Once you use the above steps to calculate the total amount you'll need for retirement, you can head to the Investor.org Savings Goal Calculator to input your values.

Let's say you want to save $625,000 for retirement, and you have an initial investment of $1,000. If you're currently 30, and you want to retire at 65, you have 35 years to invest your money before you start making withdrawals. If you decide to make fairly aggressive investments in index funds and stocks, for example, which yield a hypothetical annual return of 9% — according to the Savings Goal Calculator, you'll need to invest $233.56 each month for 35 years in order to have $625,000 saved up for retirement.

You can follow these same steps for any other retirement goal number and for any rate of return or length of time.

Once you know how much you need to save now, it's time to start putting it into practice. There are many different retirement savings vehicles out there and, in fact, you may already be using one through your employer: a 401(k).

With a 401(k), you can set up your account so a percentage of your paycheck is automatically invested for you each pay period. And since the money being invested is pre-tax, you'll owe taxes on the amount you withdraw in retirement. A traditional IRA works the same way, except it is not a company-sponsored account so you will have to set up the account yourself.

With these pre-tax savings vehicles, you'll also want to account for paying taxes on your withdrawals in retirement. It's best to speak with a financial advisor or tax professional for specifics as they pertain to you.

However, if you've been saving money through a post-tax retirement account — like a Roth IRA or Roth 401(k) — you won't need to account for taxes when you make withdrawals in retirement. With these accounts, you're investing post-tax money (money that has already been taxed) so those contributions will grow over the years and you won't owe any taxes on withdrawals.

Not all companies offer the option to invest in a Roth 401(k), however, anyone can open up a Roth IRA simply by creating an account through a brokerage like Fidelity or Charles Schwab (it takes just a few minutes to create and fund your account with a linked bank account). And once you open and fund your account, you'll need to pick your investments.

If you want a more hands-off approach, you might consider using an app like Wealthfront or Betterment, which use robo-advisors to pick the investments that best suit your goals based on things like risk tolerance and how long you have until retirement.

Bottom line

Thinking ahead to what your life might look like in retirement might encourage you to start taking small steps that can have a big impact over time. The 4% rule is a popular estimate for how much money you'll need to save to last 30 years in retirement.

But whether you choose to follow the updated 3.3% guideline or stick with the traditional 4% rule of thumb, figuring out your retirement number is only part of the work. You'll also need to know how much money to start saving right now in order to reach that goal — which can be done through the use of online savings calculators. But once you're ready to really dive into some other specifics, you might want to seek assistance from a financial advisor.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.