Withdrawal Rate and What It Means for You

One of the most important factors to consider when thinking about retirement is your withdrawal rate. It comes up time and time again in articles and books on retirement, but is rarely fully explained and often becomes a topic that people gloss over.

Let’s change that.

Withdrawal rate simply refers to the amount of money you’re taking out of your savings each year (unless otherwise specified). So, if you’re taking $500 a year out of your savings account, that’s your withdrawal rate.

Most of the time, withdrawal rate is expressed as a percentage. So, let’s say you have $100 in your savings account and you withdraw $1 per year, your withdrawal rate would be 1%. Makes sense, right?

Here’s where things get tricky. With almost all investments, that investment continues to earn money during the years when you’re withdrawing money. So, with that savings account example above, it might be earning 1% interest during that year, so although you might withdraw $1 per year, it’s also earning $1 per year. So, at the end of the year, you will have taken out $1 but the account will still have a balance of $100 – the $1 in interest plus the $99 that you left in the account.

That’s why withdrawal rate is usually based on the amount in the account when you started making regular withdrawals.

Let’s clear this up with another savings account example. You have $1,000 in there, and you’re committing to withdrawing $10 each year. Your withdrawal rate is 1%. However, that account earns 1.25% interest. So, each year, you’re withdrawing $10, but during the first year, the account actually earns $12.50 in interest, leaving it with a balance of $1,002.50 at the end of the year. The next year, your withdrawal rate is still 1% and you’re still withdrawing $10 (because that’s all based on the starting balance of $1,000), but it’s earning 1.25% on the current balance, which means that it earns $12.53 in interest that year and ends up with a balance of $1,005.03 at the end of the year.

The key thing to notice here is that the withdrawal rate and the annual withdrawn amount stay the same, but the account balance can actually change over time. The withdrawal rate is based on the initial account balance and thus doesn’t change.

So, what does this all have to do with retirement?

Retirement calculations follow this same exact principle. When you retire, your goal should be for your retirement savings to last the rest of your life, right? You don’t want your money to run out when you’ve still got years of life left in you.

So, what people typically do in retirement is that they figure out a withdrawal rate and then withdraw that amount each year from their account. Let’s say, for example, that they have $1,000,000 in retirement savings at the start of retirement and decide on a 4% withdrawal rate. That means that, each year, they’re going to take 4% of $1,000,000 – or $40,000 – out of their account.

In other words, you might retire at 65, you hope to last until you’re in your 90s, and so you want to be able to withdraw 4% – $40,000 a year – for 30 years.

If you do the simple math – $40,000 times 30 – you’ll see that over those thirty years, you’re pulling $1.2 million out of the account, but it only has a balance of $1 million at the start. That means that the money that stays in the account had better be invested well, in order to earn that extra $200,000 in investment income.

Let’s play around with this a bit. Let’s say you choose a withdrawal rate of 5%. That would mean you’d take out $50,000 a year over 30 years, or $1.5 million. Your investments would have to come up with another $500,000 along the way as you’re drawing it down. That’s a pretty tall order!

On the other hand, you might choose a withdrawal rate of 3%. That would mean you’re taking out $30,000 a year for 30 years, or $900,000. In that case, you can actually afford to lose $100,000 in investments along the way and still be okay!

What you can see here is that the higher your withdrawal rate, the less safe everything is. The more money you take out each year, the less likely it becomes that your investment is going to last from the start of retirement to your passing.

(Yes, that’s an obvious point, but it’s an important one.)

Of course, you have another factor pushing the other way. If you go for a safer withdrawal rate, that means less money each year for you to live on. The person that takes $30,000 out of their investments each year might be safer than the person who takes out $50,000, but they have far less to live on.

The trick, of course, is to find a balance, and that balance is called the safe withdrawal rate. It’s the percentage of the initial balance you can take out each year and expect, with a high likelihood, that your investments will last until you pass away.

Obviously, a safe withdrawal rate comes with some assumptions. It assumes that you have a certain number of years to live between retirement and death – usually, thirty years is used. Also, it depends a great deal on how your money is invested and what the economy is like when you’re in retirement. Typically, a safe withdrawal rate is calculated with the idea that you’re invested fairly aggressively and that the market does pretty poorly by historical measures over that timeframe.

So, what exactly is a safe withdrawal rate, then? Most experts tend to agree that a safe withdrawal rate for retirees with a heavily diversified 401(k) is somewhere between 3% and 4%, with a few suggesting a bit lower, as low as 2.5%.

In other words, if you set your withdrawal rate at 3% when you retire and stick to that amount and your retirement investments are diversified but have a healthy amount in stocks, most experts agree that your retirement savings will last you for 30 years (at least).

Of course, you can set a different withdrawal rate if you choose. A higher one means that there’s a lower likelihood of your money lasting for 30 years; a lower rate means that it’s extremely likely to last for 30 years with money left over at that point. The choice is up to you.

How is this useful in retirement planning? You can use that “safe withdrawal rate” to see how much you’ll have to live on when you retire.

For example, let’s say you think you’ll have $600,000 saved up when you retire. If you multiply that by the safe withdrawal rate of 3%, you get $18,000 per year. Is that enough, along with Social Security and any other benefits you might have? What about inflation – remember, prices will go up, too. You might want to consider accelerating your savings.

A safe withdrawal rate simply helps you get a realistic picture of what your finances will look like after you retire. It suggests how much you can safely withdraw each year, and you can use that along with your Social Security estimates to figure out if that’s enough or if you need to start bumping up your retirement savings.

Good luck!

The post Withdrawal Rate and What It Means for You appeared first on The Simple Dollar.