What is the 4% rule?

If you’ve been reading about F.I.R.E. for a while, you’ve probably heard about the 4% rule. But what is it exactly?

Simply put, it states:

You can safely withdraw 4% of your portfolio every year for infinite years.

It’s essential to have a retirement calculation that works for infinite years because otherwise, financial advice would be highly dependent on:

1. How old you currently are
2. How long you plan to live

Not only is this a bit morbid, but it also makes the math difficult when deciding between retiring at 55 and 60.

How does this work?

Think about it. If you had 1 million dollars in cash (no interest), and you are wondering if that’s enough to retire.

If you spend $100,000 per year and only plan on living for ten years, then yes! If you spend more than that or live longer, it’s no longer enough!

The 4% rule considers the average return on investment and gives you a safe percentage you can withdraw and keep your nest egg.

Examples:

Now let’s say you take that million dollars and invest it in bonds that average a 6% return. According to the 4% rule, you can safely withdraw $40,000 of it each year without ever depleting it. Let’s look at five years of this plan:

• Year 1: $1,000,000 – $40,000 = $960,000
• Year 2: $960,000 + $48,000(interest) – $40,000(4% safe withdrawl) = $968,000
• Year 3: $968,000 + $48,400 – $40,000 = $976,400
• Year 4: $976,400 + $48,820 – $40,000 = $985,220
• Year 5: $985,220 + $49,261 – $40,000 = $994, 481

There we go! 5 years in, taking your $40k per year, and you have more money than when you started!

The 4% rule gets even better!

The coolest thing is that, while your total investment is going up every year, that 4% becomes worth more and more! So a more accurate five-year description would look like this:

• Year 1: $1,000,000 – $40,000 = $960,000
• Year 2: $960,000 + $48,000(interest) – $38,400(4% safe withdrawl) = $969,600
• Year 3: $969,600 + $48,480 – $38,784 = $979,296
• Year 4: $979,296 + $48,965 – $39,171 = $989,090
• Year 5: $989,090 + $49,454 – $39,563 = $998,981

As we can see, we start with $960k after our first withdrawal. Every year after that, we make more and more (starting at $48,000), which means we can safely withdraw more and more (starting at $38,400)

Follow up reading

I still think the 4% rule is great. But it is worth pointing out that the founder of the rule has since decided it was too simplistic. Either way that’s an interesting article! If it’s too much for you, just stick with the 4% and call it a day!