The 4% Rule Is More Complicated Than You Think

by: Roger Nusbaum

Long time readers will know that I am a huge believer in the 4% rule as a sustainable withdrawal rate for retirement. More specifically I've written about taking 1% out per quarter but with no bump for inflation. The growth in the portfolio will hopefully cover inflation.

The context as noted above is sustainability of the portfolio regardless of how the portfolio pays you -- total return or dividends only (which is a nod to the dividend oriented people who might read this post if it makes its way over to Seeking Alpha).

However there is a big hiccup to the 4% rule that will be an issue for some people having to do with what types of accounts their portfolio is in.

As an example, a moderately successful 61 year old couple has accumulated a total of $850,000 in all accounts. They have modest living expenses and only two more trips of a lifetime on their list to get to and plan to work part time in retirement. They decide they are going to retire now because they each found hobby-oriented, part time jobs that pay $15,000.

Let's say their lifestyle requires $45,000, their net income from their jobs will be $25,000 and they want to wait until they are 70 to take their Social Security. In this example they only need a 2.3% withdrawal rate for the time being which looks pretty good.

Here's the wrinkle; they have $600,000 in traditional IRA accounts and $250,000 in taxable accounts.

Moving away from this example for a moment, in terms of tax efficiency for withdrawals, the (financial planners) book says you avoid withdrawals from traditional IRAs until you are required to do so (assumes a traditional IRA is not the only source of funds like in the above example).

The couple above then must decide whether to take the $20,000 just from the taxable account at a potentially unsustainable 8% or go the more sustainable but less tax efficient route of taking some from traditional IRA - -in the latter case the breakdown would likely be $10,000 from the taxable account (4% of $250,000) and $10,000 from the IRA bumped up to $11,764 if they are in the 15% tax bracket.

A common strategy in the face of this is to make tax efficiency the priority even if it means exhausting the taxable account and letting the IRA (hopefully) grow. In ten years a 50/50 portfolio could grow by 50% assuming the equity portion doubles -- rule of 72 at 7% (assuming linear returns is a bad idea but to make this post simpler...).

In our working example, when the couple is 71 the unwithdrawn upon IRA could be worth $900,000, they are now getting the max Social Security and it is very unlikely that the taxable account is exhausted because 8% is not 20% but it would be probably be smaller (8% out, 7% growth in equities, nothing from fixed income in a 50/50 portfolio).

Calculating it out, taking $20,000 out at the start of the year and getting 3.5% growth on the remainder of the taxable account works out to a balance $109,809 in the taxable account when they turn 71. The significance of 71 is that is effectively when many people start taking RMDs from IRAs.

Everyone needs to come at this based on their own beliefs, hot buttons and quirks. Yes ROTH IRAs can be a solution to this issue but paying less income tax going in is appealing too.

The point from my perspective is not that anyone should do one thing or the other but that everyone should take the time to understand this dynamic so they are more informed when it comes to execute their retirement.