What is the 4% rule and how can it help you save for your retirement?

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Saving for retirement can seem daunting, especially when you don’t know where to start. But the 4% rule, a popular guideline used to figure out how much you can comfortably spend with your retirement savings each year, may actually provide clues as to how much you’ll need to retire and what you need to do. to succeed.

“The definition of the word ‘retirement’ is actually ‘stepping away from a situation’, but in reality, retiring is actually starting a new chapter in your life,” says Scott Meyer, wealth manager and partner at Merit Financial Advisors. “It’s not about leaving the workforce; it’s about starting a new chapter, and it’s important to think about what this new chapter will look like and how you can put a dollar value on it. . “

According to Meyer, the 4% rule is a great place to start thinking about our retirement savings. Here’s what you need to know.

What is the 4% rule?

The 4% rule states that you should be able to live comfortably from 4% of your money in investments during your first year of retirement, and then increase or decrease that amount slightly to account for inflation each following year. Based on historical data, living on just 4% will allow you to use your retirement portfolio to cover your expenses for 30 years.

“The 4% rule first became popular in the mid-1990s,” Meyer explains. [Research] “Found that if you took out 4% each year in retirement, there would actually be a high probability that your money would outlive you in retirement. “

Recently, some financial planners have reassessed the 4% practice due to the possibility of lower Social Security distributions in the future and concerns that retirees will need to extend their savings a little longer. As a result, many financial planners now believe that 3.3% may be a more comfortable amount to withdraw each year.

“Because the 4% rule is so popular, it’s been contested for decades because it’s such a widely used measure that people want to make sure it’s always accurate and relevant,” Meyer says. “The argument for which this number should be higher or lower depends on the environment you find yourself in, the environment of the future market and the future economy. The length of our life also has a big impact on the how much we will need. Like Therefore, there are arguments that we should withdraw less each year because we are living longer and we will need more money. “

The 4% rule and the updated 3.3% rule are actually rules of thumb about how you should spend money in retirement, not explicitly how to save for it. However, having an idea of ​​how much money you will be spending during your non-working years can help you work backwards to determine how much you will need to have saved in the first place.

How do you work backwards using the 4% rule?

“There’s a quote that says you should ‘start with the end in mind’,” Meyer says. “So you need to figure out how much you will need to spend each year in retirement and use that 4% rule of thumb to determine how much money you will need to last through retirement.”

To determine how much money you need to save before you retire, you first need to estimate how much money you spend each year in retirement. To do this, you should consider the following costs as a starting point:

  • Rent or mortgage
  • Health and long-term care costs
  • Annual cost of groceries
  • Annual cost of drugs
  • Transportation costs (whether car and maintenance costs or public transport)
  • How much you plan to spend on travel each year
  • Pet expenses

This list is not exhaustive, as everyone’s expenses will be different, especially when you consider the lifestyle you want in retirement. But you can use the expense categories above to start thinking about some of the costs that will need to be covered in retirement. And one cost Meyer thinks people shouldn’t underestimate is health care.

“Most people are concerned about health care-related expenses, so it’s important to understand the premium costs and out-of-pocket costs of health care in retirement,” says Meyer. “And at the same time, people worry about the costs of long-term care when they can no longer take care of themselves. It can become very expensive if not well managed.”

Once you’ve added up all of your potential costs per year, you might also want to account for some discretionary spending money for any other expenses that might arise – this could mean adding an additional $ 5,000 to the total you have. just calculate. Let’s say you estimate that your potential annual expense will be $ 40,000; with an additional $ 5,000 as a cushion, you will spend approximately $ 45,000 per year in retirement.

Next, you should consider approximately how much of that money you will receive through federal benefits such as Social Security. Social security administration has a online benefits calculator this allows you to estimate how much you might receive from Social Security based on your current income and when you expect to retire.

Let’s say you expect to receive around $ 20,000 per year from Social Security distributions. This means that instead of withdrawing $ 45,000 from your retirement savings each year, you will only need the difference between $ 45,000 and $ 20,000, or $ 25,000.

Now that you know how much money you will need to withdraw from your retirement savings each year, you can use the 4% rule to determine the total amount you will need to save before you retire. Just take $ 25,000 and divide it by 0.04 to get $ 625,000. In other words, $ 625,000 will last you 30 years if you only withdraw $ 25,000 (4%) per year. And if you want to follow the updated 3.3% rule, you would divide $ 25,000 by 0.033 to get $ 757,575.

How can you start saving now?

Knowing how much money you will need to have saved before you retire can help you get an idea of ​​how much you should be setting aside right now to achieve this goal.

Once you have used the steps above to calculate the total amount you will need for retirement, you can head to the Investor.org savings goal calculator to enter your values.

Suppose you want to save $ 625,000 for retirement and have an initial investment of $ 1,000. If you are currently 30 and want to retire at 65, you have 35 years to invest your money before you start making withdrawals. If you decide to make some pretty aggressive investments in index funds and stocks, for example, that yield a hypothetical 9% annual return – according to the savings goal calculator, you’ll need to invest $ 233.56 each month for 35 years old in order to have $ 625,000 saved for retirement.

You can follow these same steps for any other retirement goal and for any rate of return or duration.

Once you know how much you need to save now, it’s time to start putting it into practice. There are many different retirement savings vehicles out there, and in fact, you may already be using one through your employer: a 401 (k).

With a 401 (k), you can set up your account so that a percentage of your paycheck is automatically invested for you each pay period. And because the money invested is before taxes, you will have to pay tax on the amount you withdraw in retirement. A traditional IRA works the same way, except that it is not a company sponsored account, so you will need to create the account yourself.

With these pre-tax savings vehicles, you will also want to record the payment of taxes on your withdrawals at retirement. It’s best to speak with a financial advisor or tax professional to find out the details that apply to you.

However, if you’ve saved money through an after-tax retirement account – like a Roth IRA or Roth 401 (k) – you won’t need to book taxes when you make withdrawals in retirement. With these accounts, you invest after-tax money (money that has already been taxed) so that those contributions will increase over time and you won’t owe any tax on withdrawals.

Not all companies offer the option of investing in a Roth 401 (k), however, anyone can open a Roth IRA simply by creating an account through a brokerage firm like loyalty Where Charles Schwab (it only takes a few minutes to create and fund your account with a linked bank account). And once you’ve opened and funded your account, you’ll need to choose your investments.

If you want a more hands-on approach, you can consider using an app like Wealth front Where Improvement, who use robo-advisers to select the investments that best match your goals based on factors such as risk tolerance and how long you have until retirement.

At the end of the line

Thinking about what your retirement life might be like might encourage you to start taking small steps that can have a big impact over time. The 4% rule is a common estimate of how much money you will need to save for the last 30 years in retirement.

But whether you choose to follow the updated 3.3% guideline or stick to the traditional 4% rule of thumb, figuring out your retirement number is only part of the job. You will also need to know how much money you need to start saving right now to achieve this goal, which can be done with the help of online savings calculators. But once you’re ready to really dive into other details, you might want to seek help from a financial advisor.

Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.

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