Simply put it’s a good guide as to how much a retiree can withdraw from investments, keep up with inflation and not run out of money during retirement. The rule has it critics, but it still remains a good guide for most people.
Let’s say you determine that to maintain your lifestyle in retirement you need $60,000 a year income. Social Security will provide some of that for most people and for a relatively few there will be a pension. The 4% rule will be applied to the amount you need from investments after considering other sources of steady income.
Let’s say the $60,000 actually is $45,000 net of other sources. To generate that $45,000 for life in retirement (defined as about 30 years), you need to start with $1,125,000 in investments. The 4% rule assumes 60% invested in stocks and 40% in bonds.
So, in the first year you withdraw $1,125,000 X 4% or $45,000. In subsequent years you withdraw $45,000 plus inflation. Let’s say inflation is 2%. In the second year you withdraw $45,000 plus another $900. (2% of $45,000). The $45,000 is a constant, the inflation amount variable.
You can withdraw less if circumstances permit, but if you withdraw more, you put your plan at risk.
If you receive cash dividends or interest from your investments they should be calculated as part of you regular withdraw, not additional.
Beginning at age 73 required minimum distributions RMDs from IRAs, 401k plans, etc. exceed 4% and increase each year thereafter. If the RMD should exceed the amount called for by the 4% rule, including the inflation adjustment, you may want to reinvest the difference so your plan stays on track. That extra could be part of an emergency fund.
If you are more conservative with investments and put less in stocks, the rule will not work. If you retire early beyond a 30 year or so life expectancy, the rule will not work.
The 4% rule is calculated to cover a long retirement. If you look at actuarial tables you will see life expectancy at age 65 is eighteen years for men and 20.6 for women. The 30 year assumption is a cushion and after all, many people will live beyond those average twenty years. Running out of money ten years before the end ain’t good.