The ideal withdrawal rate for retirement does not touch principal. Ideally, you want to live off your retirement principal income for the rest of your life. This way, you won't have to stress about running out of money.
Further, if you never touch principal, you can leave a legacy for your children and charities following the Legacy Retirement Philosophy. Leaving a legacy honors your family name and helps others for years to come. As you get older, I promise you will think about what you want to leave behind to make the world a better place.
The ideal withdrawal rate for retirement also allows you to pass on your wealth. You can amass up to the estate tax threshold so your heirs don't have to pay the onerous 40% estate tax rate. Further, you can give away your state to charities that may need your money the most.
Your goal, if you choose to accept, is to create a large enough estate that will provide incredible passive income for your loved ones long after you are gone. This is what endowments do.
Why not consider doing the same if you are a magnanimous and financially savvy individual? For 2023, individuals can accumulate an impressive $12.92 million before having to pay an estate tax upon death. The estate tax threshold limit changes every year.
A 4 Percent Withdrawal Rate Is Too High
I always scratch my head when I hear advisors talk about the “4% withdrawal rule” or any withdrawal rate that's greater than a risk-free rate of return for that matter.
Times have changed folks. Interest rates are close to zero. The stock market isn't a slam dunk with all that's going on in the world. Further, we are living much longer now.
The proper safe withdrawal rate = 80% X the 10-year bond yield, at least for the initial two or three years in retirement as you figure out your new life out.
When the 4% Rule was conjured up in the late 1990s, the 10-year bond yield was at 6%. Therefore, of course you could withdraw at 4% since you could earn 6% risk-free back then!
There are so many variables that it is impossible to calculate a bullet proof withdrawal rate rule unless that rate is 0%. Sure, there's a 99% chance you will die before 110. There's also a 99.9% chance you'll die before 150, but who really knows? We might be one with machines by the year 2030 and live forever!
Instead of thinking about how much you can withdraw to bleed your retirement funds down to $0 by the time you die, I highly encourage everyone to think about leaving a financial legacy for your loved ones. Make your estate so vast that it will never run out of money.
Even if we fail to come up with a perpetual giving machine to leave for others, the end result will be much better than if we only focused on ourselves.
The Ideal Withdrawal Rate In Retirement
Let's assume everybody retires at 65 with $1 million dollars. Becoming a millionaire is fast becoming a rule rather than the exception thanks to inflation. Therefore, don't think becoming a millionaire by retirement is out of reach.
You've now got to calculate your life expectancy, health care costs, market returns, withdrawal rate, and living expenses. These are five variables that must be figured out.
There are 120 different ways to arrange these variables to make them work if each is a stand alone permutation. Let's say each of the variables has multiple permutations. There will literally be hundreds of thousands of combinations to choose from.
Even with the basic assumption of retiring by 65 with $1 million dollars and a 4% withdrawal rate yielding $40,000 a year, this might not be reasonable for many people. Everybody's lifestyles are difference.
The calculations therefore become simply academic gymnastics that help us feel better about our chances of living a comfortable retirement. The more conservative our assumptions (leaving money left over), the better we will feel and vice versa.
Different Retirement Withdrawal Rate Scenarios
It's fun to run various scenarios for retirement as I did with my 401k. You can do so easily since it's free and easy to do nowadays.
Years ago, I ran a Conservative, Base, and Blue Sky Scenario with Empower. I came up with inflation and tax adjusted amounts of $500,000, $1 million, and $2.5 million after 25 more years of saving and investing. A $2 million spread is huge and not something one can easily plan for.
With $500,000, $1,000,000 and $2.5 million inflation and tax adjusted, I will have $20,000, $40,000, and $100,000 a year to live off for another 25 years until I'm 90, assuming I retire at 65. And what do you know? The annual retirement money is based off a 4% withdrawal rate assuming zero growth.
Everybody can probably comfortably live off $40,000-$100,000 a year in retirement in today's dollars. But again, what if we live until 100, or what if health care costs skyrocket further? What if we have an even more aggressive President who decides to raise tax rates on everyone and not just those making over a certain amount?
All of these assumptions are based off other assumptions. If one assumption is wrong, the entire retirement foundation may be off.
If you've ever seen the cult movie Memento with Guy Pierce and Carrie-Ann Moss, you understand exactly what I mean.
The Ideal Withdrawal Rate Should Be Based On Two Figures
To make things simple, use the below two figures to calculate the ideal withdrawal rate in retirement.
1) The 10-year government bond yield.
The 10 year US Treasury yield changes every single day and is another metric for the risk free rate of return. For the past 30 years the 10 year bond yield has come down due to lower inflation and more efficient economic policies.
I encourage everyone to adjust their annual withdrawal rate based on the average rate for the past 12 months. The 10-year bond yield is currently around 4%.
2) The S&P 500 dividend yield.
The current S&P 500 dividend yield is roughly 1.8%. Dividend yields can rise when dividend payout ratios increase or the market tanks. If what you are mainly focused on is income, then withdrawing at the rate of the market's entire dividend yield will mean that you will never touch your principal.
Your principal might collapse, as many portfolios did between 2008-2010, but your portfolio will never be further reduced by your own doing.
If you look at the historical chart, you can see how a 4% withdrawal rate made sense in the 1970s, 80s, and early 90s, but not now. Not even close. If you are a reader not from America, choose your own market's dividend yield instead.
The two figures are at very similar levels as you can tell. It's up to you to decide which asset class is a better investment based on your risk tolerance. If you are an early retiree looking to tap your IRA penalty-free, I wrote about Rule 72(t) and creating a perpetual income stream.
Better To Be Conservative With Your Retirement Withdrawal Rate
Some of you might be thinking that it's foolish to die with too much money. In many ways, you are right. Paying a 40% estate tax is truly a waste when you could have donated your money while living or spent the money on a better life.
But remember, we are talking about financial security and leaving money to those we care about. Our loved ones don't have to be our daughters and sons. They can be a cause we care about such as fighting cancer, supporting the arts, helping an alma mater, or providing funding for foster children.
If you end up old and broke, there's little hope of getting back on your financial feet for the remaining years of your life.
Using the S&P 500 dividend yield or the 10-year treasury yield as a safe withdrawal rate will ensure that you do not run out of money in retirement. When you are in retirement, only then will you truly know how much you will need to be happy. Just go about your adjustments in baby steps.
A Lower Safe Withdrawal Rate Is Better
If you would like to do a deeper dive into the proper withdrawal rate, then I suggest you read my post: The 4% Rule Is Outdated: Consider A Lower Withdrawal Rate Instead. It was meant with a lot of backlash, but the logic behind lowering the ideal withdrawal rate is sound.
When we shift our retirement withdrawal rate to a level which does not touch principal, we suddenly start changing the way we view money. We save more because we're not only thinking only about ourselves anymore.
A lower withdrawal rate makes us invest more carefully because people are counting on us. We also do more research and invest more carefully with a lower ideal withdrawal rate.
Inflation is a perpetuity, so too can your retirement funds become through CDs, real estate crowdsourcing, stock dividends, and royalties. The more income streams you can produce the better. With relatively low interest rates still, retirees need to inch up the risk curve to find higher yields. My favorite way to do so is through a private real estate fund that invests in the Sunbelt.
When it's time to start sleeping in because you no longer have to work, you just might not need to withdrawal any of your retirement funds at all!
Generate More Retirement Income Through Real Estate
Real estate is my favorite retirement income source because it is a tangible asset that is less volatile, provides utility, and generates income.
In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. With interest rates down, the value of cash flow is up. Further, the pandemic has made working from home more common.
Today, real estate makes up 40% of my net worth and generates over $150,000 a year in passive retirement income. Without real estate, I wouldn't have had the courage to retire early in 2012 and live free.
Take a look at my two favorite real estate crowdfunding platforms.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and manages over $4 billion for 500,000+ investors. It predominantly invests in residential and industrial real estate in the Sunbelt region where valuations are lower and yields are higher.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities that have higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio. Just make sure to due extra due diligence on each sponsor and deal.
Manage Your Finances Better
I recommend signing up with Empower, a free online wealth management tool that tracks your net worth, aggregates all your accounts so you know where your money is going, and provides useful analysis on your investment portfolios. I ran my 401(k) through their “401(k) Fee Analyzer” under the Investment tab to discover $1,700 a year in fees I had no idea I was paying!
You can also run very useful retirement scenarios based on various return assumptions in your retirement accounts through their Retirement Planning Calculator. Unlike other calculators, Empower uses your real data and Monte Carlo simulations to produce realistic financial results. There's no better free online wealth management tool.
For more Financial Samurai, you can sign up for my free weekly newsletter here. The Ideal Withdrawal Rate For Retirement Does Not Touch Principal is a Financial Samurai original post. I've been helping people achieve financial independence since 2009.