4rulesmall

If the information so far is starting to click in your head, you may be wondering how much you need to retire and if you’ve done any personal finance research online you’ve probably come across the 4% rule also known as the 25 times rule.

The 4% rule came from the trinity study and it basically states that looking into the history of the stock market, no matter what year you retired, you generally were safe as long as you only used 4% of your investments. In other words, in general, you could pull out and spend 4% of your investments each year without eating away at the principle of your investments. The reason for this is the market on average has historically returned around 7%-10% per year. take away a couple % for inflation and you’re left with around 4% or more. spend less and your investments should in general keep right on increasing on average.  You investments could run away and increase each year while you’re still not making and income from work.

There is a lot of controversy over the 4% rule but the main concern is that this isn’t obviously always a safe percent to pull out and people should not simply put blindfolds on and pull 4% out on auto pilot and spend every penny. The study says this will work nearly 100% of the time, but if you had a brain and were in a situation where for example the market crashes and your average stock price in your portfolio has gone from $100 a share to $75 a share. you just lost 25% value of your investments. In this scenario you would be smart to make cutbacks on your spending until the market bounces back. This shouldn’t be hard as most people will over estimate how much they spend per year as well as include various vacations and luxuries. Cut back some of the luxuries and maybe travel more locally while the economy is down instead of flying to another country. We also use a combination of stocks and bonds. stocks are sold when needed in retirement while times are good and bonds are sold when the market is bad. Helping you to wait out the market to bounce back.

I think we’re all smart enough to duck dive and jab with the market through bad markets contrary to what skeptics of the 4% rule say.

When considering quitting a job, this isn’t something anyone really takes lightly, almost all of us will over prepare our savings and round up what we spend each year using this 4% rule as a guide. On the flip side of that over preparing, Most people find that they actually spend quite a bit less  after retirement than anticipated. Mortgage gets paid off, kids go off to college and move out, loans get repaid, drive way less, etc.

Another reason why you shouldn’t worry about the 4% rule is if you’re like me, many of you will still bring in income after “retirement” although maybe only through odd jobs or part time jobs and such just for fun. Even if this ends up only being $15k or less per year that will make a substantial difference in how much you’ll need to pull out and in turn you’ll only see your investments keep growing over time to a point where you may finally stop making any extra income whatsoever and find it difficult to spend even 2 or 3% of your investments per year.

Last reason to not worry. We’re flexible right? I just mentioned we can scale back in a bad year but many of us may also live in expensive houses in an expensive area because that’s where the jobs were and you wanted to be in a good area for your kids. Your house is probably twice the size you need now because years ago you had growing kids that needed room. But now that you’re retired and no longer working you’re free to move. If you don’t want to move to far away, you can probably find a smaller house a bit farther away for a third the price of your current house. Or you could move to another state with lower taxes and possibly find a nice place at a 1/6 the value. Use the extra money from the sale of the home and saved tax money to put back in investments and move that 4% needed closer to 3%. Some people even choose to move to an apartment to keep their wealth as liquid as possible and give them the ability to move around to different areas freely.

How to use the 4% rule / 25 times rule

The rule is used like a planning guide, “I’m good to retire when my 4% of my investments equals my yearly living costs.”

Or “I’m good to retire when I have 25 times my yearly living costs in investments.”

You will need to

4% rule Example: Currently I spend around $24,000 each year, 4% rule says I need $600,000 in investments. 600,000 x .04 = 24000

25 times rule: $24,000 per yea x 25 = $600,000 in investments needed. 

Note, In case you’ve heard this too: I’ve heard people say thoughtless things like “I’ve heard you’ll need like two and a half million to retire!” yeah that’s technically true.. if you blow through $100,000 per year. $100,000 x 25 = $2,500,000.

Most large corporate news sites(who get most of their ratings from gloom and doom stories) you’ll notice cast a dark grey shadow over our 4% rule, noting that there are situations it doesn’t work. They may be right if you happen to be very inflexible financially, have a portfolio of hand picked stocks over low cost index funds, no bonds and constantly try to time the market. Note: don’t try to hand pick stocks or time the market.

*Here is a news site who put some thought into their article and a paper from Stanford University that shows how you can go wrong with the 4% rule.

Check out Mr Money Mustache and Jim Collins stock series if you are interested in more in depth information on the 4% rule.

twitter
Facebooktwittergoogle_plusredditpinterestlinkedinmail