One of the things we consistently get questions about is why we’re taking the two-phase approach, especially with well-funded retirement accounts already in place, instead of starting to tap those funds now, and already being able to retire. We don’t think it’s a good idea to see taxable and tax-advantaged funds as one big pool of money. And we definitely don’t think it makes sense to apply the 4% rule to your total balance to figure out what you can spend in your early retirement years, before you can access your tax-advantaged funds without penalty. (We don’t think you should be using the 4% rule at all, actually, but that’s another post.) Or even that it’s a fine idea to plan on level spending over your lifetime. Tax rules can and do change, which could spoil your early withdrawal plans. The problem is that relying too heavily on your tax-advantaged funds for early retirement makes it easy to accidentally spend some of the money older you needs later. And by the time you realize that you should have saved that money for later instead of converting it or withdrawing it early, you’ll have a much harder time earning more income than you would have in your 30s/40s/50s. But as for SEPPs and the Roth conversion plan, we see a few other important downsides worth noting, in addition to all that stuff above about selling out future you: Forced to sell when you’d rather not: With a SEPP, you must withdraw equal amounts each year, even if your investments are tanking and you’d rather not sell shares. If you’re reliant on a Roth conversion for your cash flow, you might be forced into the same situation, even though there are no tax rules forcing you to sell shares in a down year.
Retirement is supposed to be a time of simplicity, when you relax, spend your time however you want, and live on your hard-earned savings. Unfortunately, your retirement probably won’t have the kind of financial simplicity you’re dreaming about. As a retiree, you’ll have important financial decisions to make. And one of the biggest of those decisions is how much money you can and should be taking out of those retirement savings accounts every year.
The 4% rule
Money experts love to come up with rules and give them catchy names. Some of these rules even work, but because economic and financial environments are always changing, even the best rule typically doesn’t work forever. The 4% rule is a great example. It was first developed in 1994, based on the work of a financial analyst who studied historical stock and bond returns. He concluded that a retiree could withdraw 4% of their savings annually for at least 30 years without running out of money. If you like, the rule allows you to adjust your annual withdrawals for inflation, meaning that you would increase the withdrawal amount by the inflation rate for the year.
Problems with the 4% rule
The 4% rule provides a neat, tidy way to plan retirement withdrawals. Unfortunately, this may not work as well today. It was based on historical stock returns and interest rates well before the Great Recession. Accounting for the near-zero returns of the “lost decade” of 2000-2009, the data no longer supports the idea that a 4% withdrawal rate for 30 years is completely safe. And with people living longer than ever, you might even need to look beyond 30 years as a retirement time frame. So as nice as it would be to rely on one simple number, if you want to be fairly sure that you won’t outlive your money, you’ll need to customize your withdrawal amount to your own situation.
Before you can decide how much you can safely take from your retirement savings accounts, you need to decide just what your goals are for that money. One of the biggest considerations is how long you want your retirement accounts to last. This will depend chiefly on your retirement date and expected lifespan, since these factors together will determine just how long your retirement will be, but there may be other issues to consider as well. For example, do you want to have some money left over to leave to the kids or grandkids? If so, you’ll need to be a lot more conservative in your spending than someone with a “you can’t take it with you” mentality. Once you’ve decided how long you want your retirement accounts to last (be generous here; it’s better to have your money outlive you than vice versa), the other major factor to look at is how well your portfolio has performed during the year.
Coming up with a magic number