How the 4% rule can help direct your retirement savings | Smart Change: Personal Finance

(Steven Walters)

After spending decades saving and investing for retirement, some people may wonder if they’ve done enough to be financially comfortable during those years. On the one hand, if you spend a lot in retirement, you may find yourself in financial trouble. But, on the other hand, if you spend too little, you can change yourself in the different experiences you may have in retirement. This is where the basic 4% rule may come in handy.

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using the 4% rule

One thing you’ll want to account for when figuring out your retirement finances is to make sure that you’re in a position to not exceed your savings, when the 4% rule comes into effect. The 4% rule states that retirees should plan to withdraw 4% of their retirement savings each year for 30 years without worrying about running out of their savings.

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Before using the 4% rule, it’s helpful to incorporate the “80% rule,” which states that you should aim to have 80% of your annual income before retirement to maintain your current lifestyle in retirement. Of course, this will vary from person to person because everyone has different needs in their lifestyle, and some may not want to maintain their current lifestyle, but in general, this is a good rule to serve as a baseline.

To calculate ideal retirement savings based on the 4% rule, multiply 25 by your required annual income in retirement. So, if your pre-retirement income was $100,000 — which means you’ll likely need about $80,000 a year in retirement if you followed the 80% rule — you would ideally have $80,000 multiplied by $25 or $2 million in retirement savings.

When using the 4% rule, it is also important to consider inflation when applying the rule. Ideally, you withdraw 4% in your first year, and then in subsequent years, you will adjust the withdrawal amount based on inflation for the current year. So, if you can save $2 million for retirement, in your first year, you’ll withdraw $80,000. If inflation rises by 3% the following year, you’d better withdraw $82,400.

Take advantage of different retirement accounts

One of the best things you can do when saving for retirement is take advantage of the various retirement accounts available to you, whether it’s a 401(k) plan, a Roth IRA, or a traditional IRA. Once you have used the 4% rule to ideally measure how much you should save, your next steps should be to create a savings and investment plan.

A 401(k) is the primary retirement account for many people, but even that alone may not be enough. Unlike a 401(k), neither Roth nor traditional IRAs are tied to an employer and can be opened on your own like a regular bank account or brokerage account.

If you are at the beginning of your career, you will likely want to take advantage of a Roth IRA because you can pay taxes on the front end while you are in a low tax bracket and allow the money to grow and free of compound taxes. If you’re at the peak of your career and this is likely the highest tax bracket you’ll be in, consider taking advantage of a traditional IRA because you’ll likely be able to deduct your contributions from your taxable income.

Everyone’s situation is different

When it comes to retirement, you should keep in mind that there is no one-size-fits-all approach. There is no set annual number that you will need in retirement and there is no set total savings amount, but there are good general rules that many people can use to guide their retirement savings plan. The 4% rule is by no means without its drawbacks, but if used as a proper baseline, it can be a useful tool.

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