What you need to know:

The 4% rule of thumb allows you to estimate how you can withdraw from your retirement savings every year with a high chance of success.

As somebody seeking early retirement it is natural to ask:

  • How much should I save?
  • How much can I withdraw in retirement?

We have already discussed how much your savings or FI number should be. Before we see how much we can safely spend in retirement, we need to revisit some terms:

FIRE fund: This is your retirement savings fund.

Success: This means your savings will last your entire life i.e. your portfolio does not go down completely to zero while you are alive and can always support your expenses.

Safe Withdrawal Rate: the rate of withdrawal from your FIRE fund every year for which you have a very high chance of success.

Asset allocation: The percentage of your FIRE fund invested in different asset classes such as stocks and bonds. For example an 80/20 asset allocation is 80% stocks and 20% bonds. 100/0 refers to 100% in stocks and nothing in bonds.

So how much can you withdraw in retirement?

  1. In the first year you withdraw 4% of your FIRE fund for your living expenses
  2. In the second year, you increase your withdrawal amount by the rate of inflation

Let’s look at an example; say your FIRE fund is $1M.

4% of $1M = $40K

You can take out $40K of your retirement savings for the first year’s expenses. Every year after the first year, you raise that amount by the inflation rate to maintain your standard of living

Say, inflation is 3%, your next year’s withdrawal will then be

40 x 1.03 = $41.2K.

The year after that,

41.2 x 1.03 = $42.4K

And so on. Studies show that if you have a nearly all stock portfolio (75/25 or 100/0) and a 30 year withdrawal period a 4% withdrawal rate didn’t run out of money with a 97%+ success rate

CAVEAT

The traditional retirement plan assumes you continue to work until age 65 and then your savings have to last another 25-30 years. Social security is an important component and kicks in around the same time.

Someone looking to retire much earlier than the typical retirement age can’t depend on social security payments as they kick in only in your 60’s. If you retire at say age 45 and have a life expectancy of 90 years, you have 45—50 years of retirement to plan for. In such circumstances, it becomes crucial to have your asset allocation closer to 100% stocks for better chance of success. In addition, if you lower your withdrawal rate to 3.75%, with an all stock portfolio you have a 94% success rate even for 50 year periods. If you are flexible, there are ways to aim for even better success rates, but we will consider those in a future post.