Most people who are saving for retirement are familiar with the 4% rule. According to this rule, proposed by William P. Bengen in 1994, and later confirmed by Trinity University in 1998, you can withdraw 4% of your retirement assets the first year of retirement and then increase your withdrawal for inflation each year thereafter. By following this rule, you will have nearly a 100% probability that your retirement funds will not run out over the next 30 years.
Ever since this 4% rule was proposed, people have argued whether the “right” number is a little lower or higher than 4%. But nearly every time I see this rule used to reverse engineer the amount one needs to save for retirement, the calculation is done incorrectly. Because of this miscalculation, that almost everyone on social media is making, the amount of money that needs to be saved before retirement is under estimated. I fear this error is going to cause many people to retire with not enough saved to last the rest of their lives as they try to cut the amount they have saved as close as possible in order to retire as early as possible. Let me explain how to calculate the amount you need to save before retirement correctly.
The error I see perpetuated is in how the 4% rule is used to reverse engineer the amount one needs for retirement and sounds something like this: If you can safely withdraw 4% of your retirement balance annually, and that amount will meet your retirement expenses, then you need to save 25 times your annual expenses to be financially ready to retire. At a quick glance, that seems to make sense. But in practical usage it falls short. I noticed this after I was actually living off my retirement savings.
If my projected retirement expenses are $100,000 a year, then this reverse engineering would mean I need a nest egg of 25 times that or $2,500,000 to retire. Then when I take my 4% of the $2,500,000 I have saved, I would be able to withdraw $100,000 a year to meet my expenses. The big error is in not accounting for taxes.
When I take the $100,000 out as my 4% distribution, I will have to pay taxes on the withdrawn amount. In my third year of early retirement, my effective tax rate was 15.6% federal and 8.6% state for a total of 24.2% combined income taxes. That means my $100,000 withdrawal becomes $75,800 after taxes. That will fall quite a bit short of covering my expenses.
Everyone will have a different tax situation as taxes differ among states and types of investments. In my case, I live in Oregon and all of my retirement distributions are taxable. I do not have any Roth products. My retirement money is invested in a traditional IRA, 401(k), and deferred compensation. This means I will be paying taxes with each withdrawal.
If one had most of their money in Roth products and standard taxable brokerage accounts, then their tax burden will be less, but not zero.
Forgetting to take taxes into account is a fatal flaw in most recommendations. In my case, if I had not taken taxes into account and simply multiplied my living expenses by 25 to get my retirement savings target, I would have retired and had to start making major cuts in my living expenses. That would have made me very upset about the timing of my early retirement.
There are two ways one can take taxes into consideration. The first is to add in the projected tax bill to the projected retirement expenses. In my case, I would add the $24,200 estimated tax bill to my living expenses. Then the money needed for me to live on would no longer be $100,000, it would increase to $124,200. I also need to factor in the additional tax due on the extra $24,200 I took out. Multiplying this additional money by 24.2% adds another $5,854 to the needed withdrawal. That makes the total needed $124,200 + $5,854 = $130,054. Then I could multiply the total amount needed by 25 to get the minimum nest egg I could retire on. This new number is $3,251,350. This is an increase of $751,350 over the previous calculation.
In order to safely retire, I need to work longer to save that extra $751,350. The corrected calculation stops me from retiring too early and ending up needing to scrimp or decrease my retirement expenses because my savings was insufficient due to miscalculating the amount I needed to save before I retired.
The second method involves accounting for the taxes in the 25x multiplier. In my case, taxes will reduce my available money by about 25% of what I withdraw. That means if I withdraw the safe 4% of my account each year, only 3% of the money will be available for me to spend and the other 1% of the money I take out will go to taxes.
So now I know that 3% of the 4% withdrawn from my portfolio will be spent on my living expenses. Reverse engineering my retirement number means I need to save 33 times (100/3) my projected living expenses in order to take the safe 4% withdrawal and have enough to pay the taxes and live on.
Taking my living expenses of $100,000 and multiplying it by 33 gives me a target retirement amount of $3,300,000. So, with this calculation I need to save $800,000 over the original 25x multiplier.
Both methods show that multiplying my projected retirement expenses by 25 underestimates my retirement needs by about $800,000. That is a pretty big miscalculation if I forget to include taxes.
Using the first method, I save up $3,251,350 and take a 4% withdrawal of $130,054. I pay my 24.2% taxes which is $31,473 and I have $98,581 left over to live on. A much closer estimate than before.
In the second method, I save up $3,300,000 and take a 4% withdrawal of $132,000. I pay my 24.2% taxes of $31,944 leaving me with $100,056 to live on which is just over my estimated living expenses.
Both methods arrive very close to my projected retirement income need. As you can see, leaving out the tax effect can be devastating to your retirement years.
All of these calculations assume you are only living off your portfolio income, which is often not the case. Any additional income you have, such as real estate cash flow, or social security is subtracted from your living expense need. For example, if I had $50,000 of real estate cash flow after taxes, I could remove that amount from my projected retirement expenses. In the first example, I calculated that my before tax need was $130,054. If I subtract the after tax real estate cash flow of $50,000 from that number, I get a remaining need of $80,054. Multiplying that by 25 gives $2,001,350 needed in my nest egg.
The net real estate cash flow of $50,000 reduces my retirement account needs from $3,251,350, to $2,001,350. This big reduction, $1,250,000, means I can retire a whole lot sooner with additional cash flow coming in beyond my retirement savings.
Please take into account your taxes and any additional income you might have before you calculate your retirement savings need. This will keep you from making a common mistake that could hurt your retirement happiness. Also before you retire, read my book The Doctors Guide to Smart Career Alternative and Retirement so you can avoid other common mistakes.