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Calculating your FIRE figure is easy. Just apply the 4% and sail off into the sunset with nary a care in the world, right?
As it turns out, many of us might are miscalculating the 4%, and that mistake could cost you your retirement.
Dr. Fawcett is a man on a mission to teach doctors how they can live healthy, happy, and debt-free lives–to regain control of their practice, time, and finances.
He penned today’s Friday Feature, a popular post from a recent Sunday Best. This post originally appeared on FinancialSuccessMD.com
Everyone is Using the 4% Rule Wrong
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.
The 4% Rule?
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 seems to be making, the amount of money that needs to be saved before retirement is underestimated.
I fear this error will 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 to retire as early as possible.
The Math
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 glance, that seems to make sense.
However, 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. 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.
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The Fatal Flaw
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 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 consider taxes. The first is to add 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. 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.
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. My savings were insufficient due to miscalculating the amount I needed to save before I retired.
4% Correctly
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.
I now 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 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 them 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 leftover 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.
Saving Your Retirement
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 consider 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.
Before you retire, check out Dr. Fawcett’s book The Doctors Guide to Smart Career Alternatives and Retirement so you can avoid other common mistakes.
40 thoughts on “Everyone is Using The 4% Rule Wrong”
You’re measuring your investment gains without any basis. That is, you are treating all $100,000 as gains, which isn’t realistic. Additionally, you aren’t counting the lower tax brackets for qualified dividends and capital gains. See this great article on that for more: https://www.gocurrycracker.com/never-pay-taxes-again/
“Unless that income comes from qualified dividends or long-term capital gains. In this case, a married couple can have $24,400 a year in income AND $78,750 in investment income, TAX-FREE (if that isn’t a strong signal to not work, I don’t know what is.)”
It’s less a problem with the 4% rule than a problem with people calculating their retirement expenses.
I’m sure there is a good list somewhere but clearly taxes are a retirement expense and should be included.
The other big expense I see people not include is medical insurance. They say they are ready to retire early, but can’t afford insurance. Which means they aren’t ready to retire.
And the third item I see people miss is that the calculation was for a 65 year old with a 30 year retirement. Those that retire early will need a different calculation.
Thanks PoF and thanks Dr. Fawcett!
What are your thoughts on some of Bengen’s recent statements that 4% might actually be too conservative? e.g. that a 4.5% Rule might be more accurate (and enable people to enjoy more of their lives?)
Great Article. I moved to Florida to keep my tax rate low and with these rates g lad too pay 15-20% Effective tax rate up to 400k/yr. Its exactly 20% at 400k
It’s disturbing to me that anyone would base their entire retirement on the 4% rule of thumb without getting another opinion, such as a fee only planner to run the numbers and confirm or challenge their retirement target date and number.
You might have a blind spot that results in a deficiency in your retirement plan, such as not accounting for taxes. Your financial future is too important to plan it in a vacuum!
John G, you would be surprised what people will do without seeking any outside input. Plumbers make a lot of money fixing things that home owners thought they already fixed. It is good to get advice for big decisions like retirement.
Dr. Cory S. Fawcett
Financial Success MD
As a high income, high spend family, the retirement tax considerations are critical for us. The tax deferred accounts alone are going to lead to hefty 6 figure annual RMDs. And there is talk of increasing taxes on capital gains for high income folks, so that could take an extra bite as well.
We have been buying a lot more cash flowing real estate to allow for more significant passive income in retirement. And that income that will be heavily protected from income tax by depreciation paper losses for many years to come.
At this point, our retirement assets are roughly 1/3 tax deferred, 1/3 taxable, and 1/3 real estate.
This goes to show that two people with equal net worth numbers…. say 3million are not really equal once you factor in their after tax net worth numbers and how they plan to drawdown those savings. If you figure your effective tax rates going forward there can be as much as $500,000 in difference in net worths between people with what looks like equal $3mil net worths.
Jason, you are so right. If all your retirement accounts have the word Roth in them, you will have a very different outcome, tax wise, than people like me with nothing that says Roth.
Dr. Cory S. Fawcett
Financial Success MD
Great article; within your math, are you doing taxes as married filing jointly? That provides a $24,000 reduction in overall income (I’m assuming you’re married, if not – it’s half that).
Not sure if you have a mortgage still – you can write off interest paid each year as well.
as some people are stating above; you could take 50k out of traditional and 50k out of taxable and that can help reduce actual income – although it can bite you if your traditional grows out of control by the time you’re 70.5 and RMD’s hit ya.. I’m still learning, lots of options and I love reading about others strategies.
NWOutlier (Steve)
Steve, to answer your questions, yes I am married filing jointly, my deductions on schedule A exceed the standard deduction, I haven’t had a mortgage on my home for 20 years. My investments outside of my retirement plans is mostly in real estate.
Dr. Cory S. Fawcett
Financial Success MD
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If you really want to make your numbers more accurate, you need to factor in the standardized tax deduction which is currently at $24,800. This should decrease your tax burden by quite a bit.
I also think the factor that people don’t think of when calculating the 4% rule is inflation. If I want to retire on 100k of today’s dollars but won’t be able to FIRE for another 15 years, I should be basing my retirement goal at around 150k considering an average 3% inflation rate over the next 15 years. The targeted nest egg should really be more like 3.7 million instead of 2.5 million.
This is click bait. Yes, you need to account for taxes, that is an expense that goes into your analysis. But frankly, taxes are pretty low in retirement, especially if you have a mix of accounts (deferred, roth, HSA, taxable) and don’t live in a high tax state. At least through 2025, with the expanded standard deduction you shelter a decent chunk of change to begin with.
It all depends on what your spending will look like, what types of accounts your assets are located in, and how well you’ve planned for a low-tax retirement.
Judging by the other comments, I’d say Dr. Fawcett is onto something here. Perhaps not EVERYONE is doing it wrong, but taxes are a spending category that’s often glossed over, underestimated, or ignored entirely.
Cheers!
-PoF
I long ago came to the same conclusion. The higher the earner and bigger the saver, the larger the balance in tax-deferred retirement accounts, the greater the embedded capital gains in taxable accounts, the more money in employer deferred comp accounts, and if you are lucky enough to throw in a pension, the bigger the bite taxes will take on the distribution side.
If you are counting on spending $30,000 per year from a $750,00 portfolio, the tax bite will be very small, maybe negligible. If you are counting on spending $300,000 per year from a $7.5M portfolio, well, be prepared to spend $200,000.
As a regular W2 employee taxes are a fact of life. They suck but you have to pay them and they get taken out your check automatically.
Enter early retirement you start to really notice them. Having to make quarterly state tax payments, making sure enough is taken out of multiple different account withdrawals for federal taxes while setting aside money for state taxes. Now I know why people brag online about tax avoidance strategies.
This is an excellent article and that “little thing called taxes” is usually not discussed in many FIRE articles.
Another piece of the puzzle that often is not mentioned in most FIRE or even FI articles (and not mentioned in your article either) is how to account for inflation?
If someone retires at age 60 and is planning on safely withdrawing $130,000 (for $100,000 in actual living expenses) how does inflation factor into the 33x expenses method?
$100,000 in 2021 dollars will not go as far in 2031, 2041, or 2051. It seems that this number would have to logically have increase to account for inflation. What would be a safe factor to use to account for both taxes and inflation? 50X? At what age?
I agree that taxes should be considered in FIRE but what about the following post regarding no/low tax in early retirement.
Thanks
https://www.physicianonfire.com/the-taxman-leaveth-taxes-in-early-retirement/
Thank you for pointing to the no-tax retirement article. It’s certainly possible, especially if you have good tax diversification and aren’t a big spender.
If that’s you, and I think it will be a small percentage of my #fatFIRE readership, then you can pretty much ignore income taxes when calculating your retirement needs.
So maybe the headline should be **Almost** Everyone…
Cheers!
-PoF
Excellent point! As they say, the 4% rule is not so much a rule as a rule of thumb- and this point about taxes is one good example of why.
Thanks Cory,
PFB
100% spot on here. I included tax calculations in all of my withdrawal plans. Tax law changes definitely could be a huge black swan, but even under the scenarios that you proposed the current standard deduction with all your capital gains is still enough to put your capital gains in the 0% tax bracket. So at least there’s that. I think this only becomes a problem for anyone wanting to live fat FIRE, or with expenses over 100 K per year (at the moment).
Nevertheless this is still something that should be included in calculations just the same way that inflation should be as well.
You are the first one to mention the cost of inflation in determining the amount that needs to be accumulated as well as taxes. When you factor an inflation amount, say 2.25 % annually, which may be low given the current federal spending practices, it significantly adds to the amount needed. It is particularly significant over longer periods of time because it is, in effect, a compounding interest. If you are young, say 40 years old, that 100k per year will likely translate into 200k or 300k per year just to maintain equal purchasing power just due to inflation by the time they reach retirement age. This brings two issues to the forefront. Your portfolio needs to perform well enough to keep up with inflation as well as providing growth over the same period of time to reach those multiple. If it does, then you may find your tax rate also increased because you are drawing at a taxable higher rate. This leads to the second issue, maximizing non-taxed investments during retirement. This reduces the tax drag on your withdrawals while also reducing your MRDs once you turn 72. I didn’t take that into account when I was young and always maxed out the pre-tax contributions over after taxes ones (not Roth eligible), so am now having to value Roth conversions on my IRAs. All in all, it seems that early retirement without a massive reduction of lifestyle spending or portfolio over performance (thus increased speculative risk) is an illusion and the prudent physician should closely consider the cost of retirement vs continuing to work as long as they are able.
Regarding the 4% rule, that is likely a good initial withdrawal rate, but following a solid income harvest plan of the portfolio during retirement and a variable withdrawal rate using mortality adjustments may improve the success rate and withdrawal rate over the course of your retirement.
I replied to the wrong post here, my apologies. It should have been Genevieve Gabriel above.
Thanks for spreading the word about this common error in calculating retirement “savings” needed.
Dr. Cory S. Fawcett
Financial Success MD
I included my tax liability as a line item in my retirement expenses budget after noticing it wasn’t a factor in gross “how much do you need to retire” calculations.
Great article. I like the option of the two methods you propose. I use the 33x method. The only thing I would change is the use of the verb “save”. Young professionals sometimes get overwhelmed with the notion of trying to “save $3M” or “save $4M”. I would counter that you are not actually “saving” a given amount, but rather “accumulating” a given amount. You don’t actually “save $4M” over a career, but rather you “save $1.5M” of your actual earnings (maybe less if you have employer matching” which will “accumulate” to $4M with compound growth” during the course of your career. The shorter your career, the more you must actually “save”…
Agreed. More than half our “savings” is actually investment earnings, and that proportion will only shrink as time goes on.
Cheers!
-PoF
This is certainly something to consider BUT….most physicians will have sizable taxable accounts and you can pull off these with relatively small tax burden if done carefully. Add Roth to the mix (decades of back door contributions for self and souse with compound growth plus any work Roth) and you can actually have quite minimal taxable income in early retirement.
Todd, most physicians do not have a sizable taxable account. They could have, and they should have, but they don’t have. I talk with a lot of docs that have not really paid any attention to their money and realize it in their 50s. The group reading this blog has better savings than the average doc.
Dr. Cory S. Fawcett
Financial Success MD
It is also important to remember the asset allocation of that 33x and that you need to withdraw 4% of last years total amount which might differ from year to year.
Changes in the tax laws can be a huge black swan event for all FIRE calculations. Consider any changes to the Long Term Captial Gains tax as it’s (#1) a relatively low tax and (#2) taxable accounts are a major FIRE investment source. How to hedge against tax uncertainty? Tax diversification. By having a balance of deferred tax, Roth, and taxable accounts, you can game the system to stay just within brackets and phase-outs with deferred/taxable sources and topping off expense needs with Roth.
Indeed. The ACA subsidy (which will be calculated differently this year and next with the passage of the latest stimulus package) is another one that many early retirees (but not this one) rely on.
I agree with both tax diversification and oversaving for an exceptionally low withdrawal rate if you’re able.
Cheers!
-PoF
And what about inflation? I think that’s another thing people fail to consider. I know the Trinity study took that into account and you can increase the withdrawal yearly to account for it. But I think people calculate the FI number based on their current annual expenses. I think you have to use the inflation adjusted that you project when you retire (in 15-30 years).
Exactly. If you’re a decade or more from retiring, you’re likely going to need a lot more than 25x your current expenses to satisfy your future needs.
I remind people to use the Rule of 72 as a guide to their future multiple. If you would need $3 Million to retire comfortable today with spending of $100,000 to $120,000 dollars, expect to need $6 Million in 24 to 36 years (this assumes 2% to 3% inflation).
Cheers!
-PoF
Great article. Just to be clear, the 4% rule and Trinity Study very much does account for inflation right? The consumer price index was factored in over the 30 year time frames studied and one already gets to increase spend every year by inflation under the 4% rule.
Great to point out that taxes are so often overlooked by many. Also what I think is at least equally often misrepresented is the success rate of the 4% rule for early retirees versus traditional ones. It is closer to a 45% failure rate over 60 years rather than 4% failure rate over 30 years for a 50/50 portfolio 4% withdraw for example.
Not to be too self promotey but I did write what I feel is a really solid article on some of these considerations as well if you’d allow this link to even more reading:
https://lifeoutsidethemaze.com/how-much-money-do-you-need-to-never-work-again/
Cheers 🙂
The studies establishing the 4% rule account for inflation starting when you retire.
But if you’re 10 or 20 years out from retiring, you need to base your goal # on what your expenses might be 10 or 20 years from now, and not what you spend now.
So your target might be 40x to 50x of current spending to equal 25x of future annual spending to account for inflation between now and then.
This is an excellent point. I see a lot of people in the leanFIRE movement (retiring under $1 million) trying to save to the exact penny.
Many of their budgets are not very accurate to begin with since a good portion of them are looking to retire in their 20s or 30s and think they’ll be healthy walking everywhere and eating ramen noodles 3x per day until they die of old age at 102.
Taxes put a finer point in how far off many of these budgets actually are.
Someone can claim they’ll never have medical costs but they can’t ignore paying taxes.
This is just a good reminder that budgeting errors will kill more FIRE plans than fretting over a 3.8% vs 4% SWR.
If somebody is lean-FIREing with $40k spending , they won’t be paying 24% tax.
Also they probably will have Medicaid at those numbers.
Also might just have a kid and have one of the former-DINK’s work for like one month, max out the EITC at 20k W2 income, and more or less double their spending…
My opinion is the people that are lean-FIREing are going to be just fine. because they have the spending figured out, which is the hardest part. It’s everybody else who might have a problem.
In our state, you can only have so many assets to get Medicaid so a spend down would be required. For example, some years back, my parents had $27K in assets. They were allowed to have a burial plan and a few thousand in the bank to get Medicaid. Laws are changing though so maybe a person can have good amount saved up and still qualify for Medicaid.