Should You Use the Famous 4% Rule to Manage Your IRA in Retirement?

Ideally, you'll go into retirement with a nice sum of money in your 401(k) or IRA. But one thing you don't want is for that money to run out on you in your lifetime.

Imagine being 85 years old with only a modest Social Security check when your 401(k) funds run dry. Your monthly benefits may not be enough to cover your bills, from food to healthcare to housing. That's a tough spot you don't want to be in.

That's why it's so important to manage your savings in a savvy manner. Rather than just take withdrawals at random, it's essential to come up with a strategy for removing money from your nest egg.

For years, financial advocates were big on the 4% rule. But it may not be a smart rule for you to follow.

How the 4% rule works

The idea behind the 4% rule is simple: Start by withdrawing 4% of your savings balance during your first year of retirement. Then, adjust subsequent withdrawals to account for inflation. If you stick to this system, your money should last for 30 years, which is generally considered to be a long enough period to avoid having people outlive their money. 

So here's how that might work. In Year One of retirement, you'd remove $20,000 if you have a $500,000 nest egg. Then, let's say inflation drives living costs upward by 2% during that year. For Year Two, you'd withdraw $20,400. And so forth.

Why the 4% rule no longer works

The concept of starting with a specific withdrawal rate and adjusting it as needed for inflation is a good one. The issue with the 4% rule lies with that 4% figure itself.

For one thing, the 4% rule assumes a relatively even mix of stocks and bonds. Retirees are often encouraged to load up on bonds because they're a less volatile asset than stocks -- meaning, their value is less likely to swing wildly from one day to the next. That's an important thing when you're tapping your assets to drum up cash to live on.

But back when the 4% rule was established, bond yields were higher. Nowadays, bonds aren't generating the same amount of income for people's portfolios, generally speaking. So that's one reason why the 4% rule no longer works so well.

Another reason is that people are living longer these days. That's a good thing, of course! But the 4% rule is designed to have savings last for 30 years. If you retire at age 60, you might need more than 30 years' worth of savings if you have great health and a family history of longevity. 

That's why you may want to adjust the 4% rule to 2% or 3%, depending on your investment mix, needs, and comfort zone. In fact, a good bet is to sit down with a financial advisor and talk through different withdrawal rates together. 

Of course, this isn't a step you need to take right now if you're in your 30s or 40s and are nowhere close to retirement. But if you're inching closer to that milestone, then it's a conversation worth having.

Once you establish a withdrawal rate that works for you, you'll know roughly how much annual income to expect from your savings, at least to start. And that could help you make informed decisions about the expenses you take on as a retiree.