Decumulation Confusion: The 4% Rule
In Part 1 of our decumulation series, we discussed the oft-overlooked topic of decumulation, or the spending of retirement plan assets during retirement years. In Part 2, we explored annuities as a decumulation strategy and the associated confusion for retirees. This month, we look at the 4% Rule, a time-honored method of withdrawing funds from defined contribution retirement plans. The 4% rule states that if a retiree withdraws a flat amount of 4% from his/her initial retirement balance each year, he/she is unlikely to run out of money in his/her retirement plan (some models adjust the 4% for inflation, however, otherwise, the amount remains the same each year, regardless of future portfolio performance).
While the 4% rule serves its intended purpose of preventing complete depletion of defined contribution retirement plan account balances, it does not exist in a vacuum when planning for retirement decumulation. The rule simply looks at one type of retirement plan and states that if a retiree only withdraws 4% from it, he/she will not run out of money. But does that retiree actually need 4% each year? What about additional income streams from defined benefit pension plans and/or Social Security? And what about the retiree’s actual expenses and/or taxes?
The 4% rule is not perfect, but the benefit is its simplicity. If proper retirement decumulation is too complex, the average retiree will be unable to navigate it. Below are some basics to help retirees understand the concept of proper decumulation:
- Just as it is important for employees to budget, it is equally important for retirees to do so as well. If income is greater than expenses, it is a winning formula!
- The expense side of the equation is a good place to make adjustments, if necessary. The best way to determine expenses is to track spending. This can be done manually on an excel spreadsheet, or automatically via an app that monitors bank accounts, credit cards, etc. Some expenses may decrease in retirement, while others may increase. By tracking spending, a retiree will have a well-established baseline that can then be used to budget expenses.
- Maximize the safety net of Social Security. Social Security is essentially a pension plan; it pays a flat-dollar amount each month that adjusts for cost of living. There is nothing quite like a benefit that provides guaranteed income, and Social Security does just that. The problem lies in that the vast majority of people elect to receive their Social Security benefit at precisely the wrong time, typically when they are first eligible. For most, delaying Social Security claims until the retiree is as old as age 70 makes the monthly benefit significantly larger and likely lowers the applicable taxes, as adjusted gross income may decrease as one ages, particularly if the retiree is using a Health Savings Account (HSA) in later years to pay for medical expenses.
- Consider the effect of taxes. For example, if a retiree determines that he/she needs to withdraw 4% from his/her defined contribution retirement plan to provide sufficient income, the amount after taxes may only be 2.5% (or less)! This can be mitigated by saving into accounts from which distributions are not taxed in retirement, such as Roths and HSAs (for medical expense distributions). These tax diversification options can be important in the early years of retirement, as many retirees attempt to bridge the income gap before Social Security kicks in.
- The HSA is considerably one of the best lesser-known retirement accounts. Active employees who are eligible for an HSA have the opportunity to accumulate funds without paying taxes or Social Security/Medicare taxes on their savings. What they withdraw, including earnings, is not taxable if used to pay most medical expenses, certain Medicare premiums, and even long-term care insurance premiums. From a tax perspective, that is even better than 401(k), 403(b), and 457 plans! And, since HSAs are not taxed, appropriate distributions are not counted as adjusted gross income when calculating the amount of any Social Security benefit that is taxed. HSAs can even be used like a retirement account at age 65, although there are some tax consequences if the funds are used for non-medical expenses.
- Prepare for catastrophic expenses, either by insuring against the risk (i.e., long term care insurance, excellent health insurance, etc.), and/or having a savings buffer (HSA savings can be particularly good for unexpected medical expenses). Even the best decumulation strategy can be doomed if a major uninsured expense arises!
- Don’t waste money! Almost everyone wastes money, including retirees. If a person does a little homework to save on regular expenses, the saved money plus earnings adds up over time. Taking a good hard look at expenses can also have an exponential effect. For example, far too many people live in houses that are so cluttered they buy things they already have, simply because they can’t find them! Turn that clutter into cash with sites like eBay, and resist the urge to add to the clutter. Reducing expenses and increasing income is a win-win!
- Be prepared to adjust the game plan. One thing that is certain about retirement: income and expenses will change from year to year, and that is okay. Most retirees do not run out of money because they adjust their expenses downward (or attempt to increase their income) when their income is insufficient to cover expenses in the short term. However, these same retirees do not do the opposite: spend more if their income unexpectedly exceeds their expenses. This is why a good retirement decumulation strategy is rooted in the income vs. expense equation, rather than in some fixed percentage like the 4% rule.
Just as the accumulation of retirement plan assets is critical, proper decumulation, or the spending of those assets in retirement, is equally significant. Yet, this complicated topic is often a source of confusion for many retirees. With the aging of the Baby Boomer generation and the increasing number of individuals retiring, proper decumulation has become a vital subject of retirement plan discussions.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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