Many people stress about running out of money during retirement. Because of this stress, several different guidelines have been developed regarding how much money you can withdraw from retirement accounts without running out prior to end of life. One of the most popular approaches is the “4-percent rule.”
According to this line of thinking, you can withdraw 4 percent from your nest egg each year. However, this guideline has one very important caveat, which is that it only lasts for 30 years, after which the balance will be depleted. With people living longer than ever before, however, 30 years may not be sufficient. Furthermore, more recent research has found that this approach has a number of flaws
Creating a New Approach to Retirement Withdrawal Rates
A safe withdrawal rate that has been suggested more recently by a professor at Johns Hopkins University is the required minimum distribution (RMD) rule. This approach is built around the RMDs that many retirement accounts force individuals to take once they reach the age of 72. The benefit of this rule, especially when compared to the 4-percent approach, is that it mitigates risks related to longevity, market, and sequencing.
The RMD rule says that you should withdraw money using the same calculations used to determine these required minimums. In general, RMDs are calculated for retirement accounts by dividing the balance as of the prior end of December by the life expectancy factor published by the IRS. The downside of this approach is that your budget would change each year, but likely not in a way that would radically affect your quality of life.
Many academics working on retirement have reached a similar conclusion about the benefits of the RMD rule. A research scholar from the Stanford Center on Longevity published a paper in 2017 that provides a strategy for retirees with less than $1 million in savings.
Under this system, the primary wage earner would delay Social Security payments until the age of 70 to maximize that income and then income would come from a common balanced, index, or target-date fund using the RMD rule to calculate the annual withdrawal rate.
This structure was proposed as a balanced way to mitigate risk while maximizing the amount of income available in retirement. A similar proposal has been made by the Center for Retirement Research at Boston College.
How to Use RMDs to Determine a Safe Withdrawal Rate
The IRS publishes annual Required Minimum Distribution tables that are used to determine your RMD each year. The RMD, as already mentioned, depends on a formula that takes life expectancy tables into account. RMDs for your accounts are calculated by dividing the balance by the life expectancy factor. You can apply the exact same formula to any account that you are using to fund your retirement.
The best way to understand how this works is to go through a real-life example of how the rule can be applied. Think about a married couple with the younger spouse being 65. You use this age to determine life expectancy for a couple since you need to account for the lifelong wellbeing of both partners.
Using the IRS chart already mentioned, the average life expectancy for this couple is 32. The life expectancy for a couple is always more years than for a single person in the IRS chart since it needs to account for the possible lifespan of both people. Imagine that the couple has $500,000 in an account.
Dividing this amount by 32, that couple can withdraw $15,500 for that year. As you get older, the life expectancy goes down, so the percentage that you can withdraw goes up. For example, at age 90, you are able to take out about 9 percent of your total portfolio each year, which would be about three times the amount projected above.
The Benefits and Downfalls of the RMD Withdrawal Rule
Taking the RMD-based approach to withdrawals in retirement is beneficial because it is simple. You only need to look up a number in a published chart and then divide. Also, the strategy is dynamic and reacts to market conditions, unlike the four-percent rule.
The other major benefit is that you are able to withdraw more money as you get older, which can help offset some of the anxiety about healthcare costs. Altogether, researchers have found that households using the RMD method ultimately spend more money in retirement and have a lesser chance of going bankrupt prior to end of life. At the same time, this method is not without its own downsides.
One of the major downsides was also a benefit. Because you withdraw more at the end of life, you could have problems at the beginning of retirement. People tend to spend the most at the beginning of retirement when they can travel more freely, but it is also beneficial to have additional money for healthcare costs later on. You could balance out this downside by withdrawing interest and dividends along with the RMD amount.
The other major downside is that your withdrawals could vary a lot between years depending on how the markets are doing. This fact makes it difficult to plan even if it ultimately reduces anxiety about running out of money.