Category: Financial Planning

Supercharge Your Retirement: How IRAs Can Mean Big Tax Savings for Tax Year 2024!

5/28/2025

Hello, savvy savers! Are you dreaming of a comfortable retirement but wondering how to make your money work harder and keep more of it away from taxes? You're in the right place! Today, we're unlocking the power of Individual Retirement Accounts (IRAs) – your ticket to potentially significant tax savings while building that nest egg.

IRAs are special accounts designed to help you save for the future, and their biggest superpower is the tax advantages they offer. Depending on the type you choose, you could lower your tax bill today, watch your investments grow without yearly tax bites, or even take money out completely tax-free in retirement! Let's dive into the different types of IRAs and see how they can fuel your journey to a richer retirement.

Traditional IRAs – Your Partner for Tax Savings Now

Think of a Traditional IRA as the classic way to save for retirement, often giving you an immediate tax break.

The Tax-Saving Scoop: When you contribute to a Traditional IRA, you might be able to deduct that contribution from your taxable income for the year. Less taxable income can mean a smaller tax bill in the current year – woohoo! Your money then grows "tax-deferred," meaning you don't pay taxes on the investment earnings each year. You'll only pay income tax on your deductible contributions and all the earnings when you withdraw the money in retirement. The SECURE Act also brought good news: there's no longer an age limit for making contributions to your Traditional IRA, as long as you have earned income!
Who's it For? This can be great if you think you're in a higher tax bracket now than you will be in retirement.
Real-World Example: Meet Sarah, a 40-year-old marketing manager. She contributes $7,000 to her Traditional IRA in 2024. If her contribution is fully deductible and she's in the 22% federal tax bracket, she could reduce her current year's taxes by $1,540 ($7,000 x 0.22)! That's extra cash in her pocket today, all while her $7,000 is working towards her retirement.

Key Traditional IRA Points

Contribution Limit: Up to $7,000 (or $8,000 if age 50 or older with the $1,000 catch-up).
Deductibility: May be limited if you or your spouse are covered by a retirement plan at work and your Modified Adjusted Gross Income (MAGI) exceeds certain levels. For instance, for a single active participant in 2024, the deduction starts to phase out at a MAGI of $77,000.
Required Minimum Distributions (RMDs): You generally must start taking RMDs by age 73 (thanks to the SECURE Act 2.0).

Roth IRAs – The Magic of Tax-Free Retirement Income!

Imagine pulling money out in retirement and not paying a dime of tax on it. That's the incredible potential of a Roth IRA!

The Tax-Saving Scoop: With a Roth IRA, you contribute money after you've paid taxes on it (so no upfront deduction). But here's the kicker: your investments can grow completely TAX-FREE, and qualified withdrawals in retirement are also 100% TAX-FREE. This means all those lovely earnings over the years can be yours without sending a cut to Uncle Sam, provided you meet the rules (like having the account for 5 years and reaching age 59 ½). Plus, unlike Traditional IRAs, Roth IRA owners don't have to take RMDs during their lifetime. The SECURE Act 2.0 also introduced a cool feature allowing limited tax-free rollovers from long-term §529 education plans to Roth IRAs starting in 2024.
Who's it For? This is fantastic if you believe you might be in a similar or higher tax bracket in retirement, or if you just love the idea of tax-free income later on.
Real-World Example: Consider David, a 28-year-old software developer. He contributes $7,000 to his Roth IRA. He doesn't get a tax break today, but his investments grow tax-free. If he retires at 65 and has built up a substantial sum, every penny of his qualified withdrawals – including decades of growth – is his to keep, tax-free! This could mean tens or even hundreds of thousands of dollars in tax savings over his retirement.

Key Roth IRA Points

Contribution Limit: Up to $7,000 (or $8,000 if age 50 or older). This is a combined limit with Traditional IRA contributions.
Eligibility: There are MAGI limits to contribute. For 2024, a single filer's ability to contribute phases out between $146,000 and $161,000 of MAGI. For those married filing jointly, it's $230,000 to $240,000.
No Lifetime RMDs: You're not forced to take money out during your lifetime.

Traditional vs. Roth IRA: Quick Glance

IRA Funding – Choosing Your Investment Path

Once you open an IRA, you need to decide how to invest your money. This chapter is all about your options.

The Tax-Saving Scoop: The IRA itself provides the tax shelter, regardless of the specific investments you choose (as long as they're permitted). This means within your IRA, your chosen investments can grow tax-deferred (Traditional) or tax-free (Roth) without you having to worry about annual taxes on dividends or capital gains from those investments.
Investment Choices: You generally have two main ways to fund an IRA:
- Trust or Custodial Account: This is very common and lets you invest in a wide array of options like mutual funds, stocks, bonds, and Certificates of Deposit (CDs).
What You Can't Invest In: IRAs generally can't hold life insurance contracts or collectibles like antiques or artwork.
Real-World Example: Maria has opened a Roth IRA. She decides to use a custodial account at a brokerage firm. Within her Roth IRA, she invests in a mix of index funds and some individual stocks. All the dividends and capital gains her investments generate within the Roth IRA grow tax-free, maximizing her retirement potential.

Coverdell ESAs – Tax-Smart Savings for Education (A Special Mention)

While our main focus is retirement, the guide we're drawing from includes a chapter on Coverdell Education Savings Accounts (ESAs). These aren't retirement accounts, but they use a similar tax-advantaged structure to help save for education.

The Tax-Saving Scoop: Contributions to Coverdell ESAs are not deductible, but the money grows tax-deferred, and withdrawals are tax-free if used for qualified education expenses (from kindergarten through college).
Key Features:
- Contribution Limit: Up to $2,000 per year per beneficiary (the student).
- Contributor Income Limits: Apply to those making contributions. For 2024, single filers see a phase-out above $95,000 MAGI ($190,000 for joint filers).
- Beneficiary Age: Contributions must generally be made for beneficiaries under 18, and funds used by age 30 (unless a special needs beneficiary).
Real-World Example: Grandparents, John and Mary, want to help with their granddaughter Emily's future college costs. Their income allows them to contribute. They open a Coverdell ESA for Emily and contribute $2,000 each year. The money they invest grows, and when Emily goes to college, she can use the funds (contributions and earnings) tax-free for her tuition, books, and room and board.

Simplified Employee Pension (SEP) IRAs – A Big Boost for Small Businesses & Self-Employed

If you're self-employed or own a small business, a SEP IRA can be a fantastic, simple way to save a substantial amount for retirement with significant tax advantages.

The Tax-Saving Scoop:
- For Employers/Self-Employed: Contributions are tax-deductible for the business.
- For Employees: Employer contributions (and their earnings) grow tax-deferred and aren't taxed to the employee until withdrawal (unless directed to a newly available SEP Roth IRA, where qualified withdrawals would be tax-free).
Higher Contribution Limits: This is a major perk! For 2024, an employer can contribute up to 25% of an employee's compensation, capped at a maximum contribution of $69,000 per employee. This allows for much larger savings than a standard Traditional or Roth IRA.
Simplicity: SEPs are much easier and less costly to set up and administer than many other qualified retirement plans.
Real-World Example: Alex is a successful freelance graphic designer. He sets up a SEP IRA for himself. In a good year, he can contribute a significant portion of his net self-employment income (up to the limits) to his SEP IRA, getting a valuable tax deduction now and building a hefty retirement fund that grows tax-deferred.

SIMPLE IRAs – Easy Retirement Savings for Small Employers

SIMPLE (Savings Incentive Match Plan for Employees) IRAs are another great option for small employers (generally those with 100 or fewer employees) looking to offer retirement benefits without the complexity of traditional 401(k)s.

The Tax-Saving Scoop:
- Employee Contributions (Elective Deferrals): Employees can choose to have money deducted from their paycheck pre-tax (or to a Roth SIMPLE, after-tax starting in 2023), lowering their current taxable income if pre-tax. For 2024, employees can defer up to $16,000 ($19,500 if age 50 or older).
- Employer Contributions: Employers must contribute, either by matching employee contributions (e.g., dollar-for-dollar up to 3% of pay) or by making a non-elective contribution for all eligible employees (e.g., 2% of pay). These employer contributions are tax-deductible for the business.
Vesting: All contributions (employee and employer) are immediately 100% vested – meaning the money is always yours.
Real-World Example: "The Corner Bookstore," a small shop with 10 employees, sets up a SIMPLE IRA. Their employee, Maria, elects to contribute 5% of her salary pre-tax. The bookstore matches her contribution up to 3%. Maria gets an immediate tax break on her deferrals, a "free money" match from her employer, and all of it grows tax-deferred for her retirement.
- Note on Early Withdrawals: There's a 25% penalty (ouch!) if you withdraw from a SIMPLE IRA in the first two years of participation, dropping to the usual 10% thereafter for pre-59 ½ withdrawals (unless an exception applies).

The Power of Tax-Advantaged Growth: IRA vs. Taxable Account

Let's see how investing in an IRA can outpace a regular taxable brokerage account over time, thanks to those tax benefits. We'll use the historical annual average return of the S&P 500 index, which has been around 10% (though remember, past performance is not a guarantee of future results!).
Scenario:

You invest $7,000 every year.
You do this for 30 years.
Your investments hypothetically earn an average of 10% per year.

What This Shows:

The Roth IRA is the clear winner here, providing the most spendable cash in retirement because all that growth is completely tax-free!
The Traditional IRA still significantly outperforms the taxable account because your money compounds faster without the annual tax bite on growth, even after paying taxes on withdrawal.
The Taxable Account lags behind due to the "tax drag" – the effect of paying taxes on your investment gains year after year, which reduces the amount of money left to keep growing.

The difference over decades can be truly astounding!

Your Journey to Tax-Smart Retirement Savings Starts Now!

IRAs are powerful tools that can help you build a more secure and prosperous retirement by offering significant tax advantages. Whether it's getting a tax deduction today with a Traditional IRA, aiming for tax-free income in retirement with a Roth IRA, or utilizing employer-sponsored IRAs like SEPs and SIMPLEs, the key is to understand your options and get started.
The rules might seem a bit daunting, but the long-term benefits for your financial future are well worth exploring. Consider your current tax situation, your expected income in retirement, and your savings goals.

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6 Financial Philosophies to Live By

5/9/2022

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Financial Philosophies

6 Financial Philosophies to Live By

I’m a believer that minimalism in general leads to less stress. The less material possessions enslaving your wallet, mind, and time the better. Below I lay out 6 simple personal financial philosophies to live by, which can increase your happiness in life and lead you towards financial independence.

1. Avoid DEBT
2. Save, Save, Save
3. Understand the power of compound interest
4. Diversify your income sources...get side hustles!
5. Don’t stress over timing the market
6. Invest in yourself...skills and education

Financial Philosophy 1: Avoid DEBT

Understand that taking on debt is a form of voluntary slavery. There are exceptions such as debt used for necessities, for instance, a mortgage.

Debt is a trap that can suck the happiness from your soul. More debt often means more stress. Let’s face it, if you have a lot of debt, you’re probably living outside your means.

For me free time is the ultimate form of wealth. Freedom to do what I want. Freedom to sleep in. Freedom to not be trapped in a job I hate. Freedom to travel. Freedom to live life on my terms. Having to work to make debt payments eats into my free time. This is why I AVOID debt.

Ask yourself this. How many hours a week do you have to work to afford that $500 new car payment? Let’s say you make $15 an hour and work 40 hours a week, you are bringing in $600 a week before tax. For simplicity, figure you take home about $500 a week after tax. Is it really worth working a full week every month to pay for your vehicle?

Unfortunately, debt is unavoidable in some cases. I had to take out a mortgage when I bought my house. Some of us have to take on debt to survive. Outside of debt used for survival, debt should be avoided at all costs.

If you have outstanding debt, first pay off high interest credit cards. Next pay off car loans, unless you were lucky to get a 0% APR loan, just make sure that the debt doesn’t accrue and balloon at the end of the term. Once all high interest debt is paid off, start tackling your mortgage.

Do you own your possessions or do they own you?

Do you own your possessions or do they own you? Material possessions can turn into money traps.

Vacation home? It’s going to need upkeep.
RV? It’s going to need maintenance.
Boat? Bring On Another Thousand.
Designer clothes? They’re going to go out of style.

Sometimes less is better. Minimalism can lead to happiness for some, but for most, simply living within your means and not overextending yourself can be a huge stress relief.

Corporate America is here to suck you in and make you a voluntary slave to the system. They want you to spend money, even if it’s money you don’t have. Just borrow it they say.

However the key to understand is that most debt is voluntary. You have a choice to break the mold and live life on your terms. The pursuit of happiness is the ultimate goal for most humans outside of survival. It’s up to you to decide what you value more. Debt shouldn’t be used to buy happiness.

Financial Philosophy 2: Save, Save, Save

My next philosophy is save, save, save! Outside of a huge windfall of money, decreasing your spending and or increasing your income is the only way to add to your wealth.

First save up an emergency fund.

The first step in savings is to establish an emergency fund.

How much should you have in an emergency fund? Three to six months of expenses is considered adequate by most financial planners. However, I prefer to have a year's worth of expenses set aside in a savings account for added flexibility in case of hardship, such as a job loss.

Next, reduce your spending.

After you get an emergency fund set up, find ways to reduce your spending. Use your savings to start investing. Find ways to cut your expenses such as:

Reduce or eliminate your cable bill
Cancel gym memberships (work out for free at a park, pushups, pullups, etc.)
Drive less, instead walk or bike more (get in shape and cut your gas bill)
Eat out less, meal prep instead
Lower your cellphone bill or go on a family plan with others
Stop drinking at bars
Consolidate your debt to a better interest rate (better yet eliminate DEBT)

You get the idea. The key is to make expense cutting fun. Focus on the benefits and stress reduction aspects of doing so.

The problem most of us fall into is that when they get a raise or find a better paying job, they often increase their spending in stride. If you get a $1,000 a month raise but immediately purchase a new house, boat, or new car, how much ahead are you really?

In the example above regarding the $500 a month car payment, consider this. What if instead of paying $500 on a car payment, you found a way to save $500 a month?

Assume you earned 7% per year in a well balanced mutual fund and contributed $500 per month.

At the end of 5 years, you would have $35,796.
At the end of 10 years, you would have $86,542.
At the end of 20 years, you would have $260,463.

Financial Philosophy 3: Understand the power of compound interest

There is a reason bankers are rich. It’s because they are earning interest from debt you are paying them. If you are in debt, you are doing yourself a disservice. It’s time to flip the script on the bankers and start earning instead of paying.

When I originally purchased my $120,000 home in 2010, I took out a $96,000 mortgage at 5.25% interest rate equating to a monthly payment of $530. I decided to do the math and found out that if I made the $530 payment for 30 years, I would end up paying $94,841 in interest alone. My $120,000 house would really have cost me $214,841.

I decided that I needed to pay the house off as soon as possible. It took me several years to pay off the house, but I still ended up paying almost $20,000 in interest. It’s better than $94,841, but still, that $20,000 that could have been in my wallet.

When you earn interest, it’s just the opposite. Here’s a quick example of how compound money works.

Think of every dollar you have saved as like an employee who is working for you. The more dollars or employees you have working for you, the more money you can potentially earn.

Let’s assume your investments earn 8% per year. Below is an example showing how compounding works.

Year 1: $1,000,000 x 8% = $80,000 earned for the year
Year 2: $1,080,000 x 8% = $86,400 earned for the year
Year 3: $1,166,400 x 8% = $93,312 earned for the year
Year 4: $1,259,712 x 8% = $100,777 earned for the year
Year 5: $1,360,489 x 8% = $108,839 earned for the year

At the end of the year 5 your money would have grown to $1,469,328. In year 10, you would have more than doubled your money to $2,158,925. By year 20, your $1,000,000 would have grown to $4,660,957.

You can see how these numbers can really grow as your next egg builds. The more money or employees you have working for you, the more money you will earn.

Financial Philosophy 4: Diversify your income sources...get side hustles!

Treat your employment as you would an investment strategy and diversify your income sources. Having as many side hustles as possible will help spread out the risk in your earning potential in case of a job loss. This may not be feasible for everyone, but even a few extra hundred dollars a month can make a difference.

Nobody likes to be dependent on a job. Losing your job can lead to a lot of stress, especially if you’re strapped with debt. The more sources of income you have, the more peace of mind you have if you lose one of them.

In my 20s, I worked Monday through Friday for a financial consulting firm 8:30am to 5:30pm. When I got home at 5:45pm, I would hook up a trailer to my truck and proceed to mow 1 or 2 lawns per evening until sunlight ran out. I did this for 10 years.

The benefits of this were that I developed a steady source of income and got in really good physical shape from all the physical work. Mowing lawns was my gym membership. The main drawback was that it really ate into my personal social life. I didn’t have a steady girlfriend. I missed a lot of concerts, sporting events, and late nights at the local bar with friends. But the sacrifice paid off in the long run.

Mowing lawns also led to more opportunities like laying sod and small landscape renovations. On some occasions I would clear $500 working for 4 hours on Saturday morning. This side hustle helped me pay off my mortgage early.

The real trick to a side hustle is to focus on the benefits and block the negatives out of your mind. Having negative thoughts in your mind leads to nothing but unhappiness and loss of focus.

The problem with side hustles is that most of us are limited by time. Finding a side hustle that can make you money in your sleep would be ideal, but it’s not realistic for everyone.

One of the biggest things to look for in a side hustle is flexibility of time commitments.

Get a part-time job (most obvious and probably least flexible)
Rent a room in your house on AirBnB
Drive for Uber or Lyft
Rent your car out on Turo
If you’re in a big city, deliver for PostMates
Sell products on Etsy
Find freelance work on sites like Fiverr.com or upwork.com
Teach a language online on a site like VIPkid.com
Sell items are EBay, Craigslist or OfferUp
Start a blog or youtube channel
Clean houses, mow lawns, be a part-time handy person

Financial Philosophy 5: Don’t stress over timing the market

When investing in the stock and bond markets, my philosophy is this: You can’t control the market, so why stress about it? Market timing is a waste of time for 99% of people. Why try to beat the market ups and downs? Nobody has a crystal ball. What the 1% of people that have temporarily timed the market successfully aren’t telling you is the ten times they failed and lost their shirt.

Let’s face it. The stock market is sort of like a giant casino. The allure of making a 10 to 1 or 100 to 1 home run investment can be exciting.

But thinking about and studying the market won’t change its direction. Yes you can analyze undervalued companies by combing through financial statements and valuation metrics. But market pricing is so efficient now that it’s like finding a needle in a haystack. Your time and energy is probably better spent on side hustles and making more money to invest.

Instead of market timing, focus on asset allocation. Asset allocation means dividing your investments to assets that are negatively correlated. This means that their values will move in opposite directions during bull and bear markets.

A properly allocated portfolio will minimize the risk of losing the value of your investments when markets decline. Everyone’s risk tolerance is different and there is no right or wrong answer. Historically, stock and bonds values have moved in opposite directions. When stocks decline, bond values have tended to go up in price and vice versa. This is why investors choose allocations like:

90% stocks, 10% bonds
70% stocks, 30% bonds
50% stocks, 50% bonds

You get the idea. I have ignored real estate, cash and other assets in the above scenario for simplicity. It’s important to remember that there is no guarantee that the past will predict the future, but we can use the past to anticipate and prepare for the future.

Financial Philosophy #6: Invest in yourself

Saving the best for last. Perhaps the best financial philosophy is to invest in yourself.

What do I mean by, “invest in yourself?” I mean investing the time to learn new skills and further your education.

Investing in yourself is also about developing daily habits and routines that make you a better person.

Reach out to people in your community or on social media offering to work for them for free in order to gain real life experience in whatever interests you. If you like photography, ask a well established wedding photographer if you can hold their camera bag during a few of their bookings. If you like accounting, ask a local CPA if you can shadow them. If you want to be a chef, ask a local restaurant if you can clean the kitchen while observing. You’d be surprised how many people would find this flattering and willing to help. You’d also be surprised how much and how fast you learn a skill that interests you. This also builds what I call social capital.

The way employers are hiring is changing. The days of paper or PDF resumes are dying. Employers want to see real life skills.

Taking action is the first step. It’s as simple as that. Baby steps are ok.

Investing in yourself in the best recession proof thing you can do.

Conclusion

Strengthen your mindset and make your journey to financial independence a fun one.

1. Avoid DEBT
2. Save, Save, Save
3. Understand the power of compound interest
4. Diversify your income sources...Get side hustles!
5. Don’t stress over timing the market
6. Invest in yourself...skills and education

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The 4% Rule: How much do you need to retire?

5/9/2022

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The 4% rule for retirement

What is the 4 percent rule?

Are you a millennial looking to FIRE? Or perhaps a baby boomer looking to quit the rat race? How much money will you need in your nest egg to make the dream a reality? The 4 percent rule just might be your answer.

The 4 percent rule is a guideline used to determine the amount of money a person should have accumulated in their nest egg to live on indefinitely. It was developed by three finance professors at Trinity University in the late 1990s. The goal of the 4 percent rule is to provide a safe income stream without ever running out of money, even during the worst economic crises.

Sound too good to be true? In this article, I’ll dive into the math behind the 4 percent rule, discuss some potential problems, and illustrate some examples using actual market returns.

How much money will you need to retire under the 4 percent rule? The multiple of 25

How much money will you need in your nest egg? The easy answer is to multiply your annual expenses by 25. Under the 4 percent rule, this should be enough to live on indefinitely. But, life is never easy, so let’s dig in a little deeper.

First, figure out your annual expenses. Add up everything that you spend money on, and I mean everything. Housing, food, phone bill, vacations...you get the idea.

Once you figure out your annual expenses, multiply the number by 25. The result will be your target nest egg needed to retire. For example:

If you have $30,000 in expenses, $750,000 should be your target.
If you have $40,000 in expenses, $1,000,000 should be your target.
If you have $50,000 in expenses, $1,250,000 should be your target.
If you have $80,000 in expenses, $2,000,000 should be your target.

These are target goals for your nest egg. However, I will discuss some drawbacks to this method further down.

You may have other sources of income during retirement, such as Social Security, a pension, 401k, or part time job. These additional sources of income can help reduce the amount that you ultimately need in your nest egg.

Expense tracking apps

Having trouble calculating your annual expenses?

Apps like mint.com can track your annual expenses automatically if you are willing to sync your credit card or banking account information.

I personally like to charge all my expenses on my credit card, then pay off the balance in full each month. Most credit card companies have some form of expense tracking software that will break down your expenses and summarize them by category, making it very easy to track your annual spending.

Let’s assume you’ve reached your target nest egg...What asset allocation should you use during retirement with the 4 percent rule?

Asset allocation is a personal choice based on risk tolerance. Generally speaking, most people prefer a conservative allocation during retirement to prevent against wild price fluctuations in the market.

Your risk tolerance is up to you.

Some may prefer the safety of FDIC insured savings accounts and CDs, but don’t expect high returns. In fact, the 4 percent rule probably even work if you use this method, unless your FDIC insured investments happen to earn over 4%, which hasn’t happened in a long time.

Others may prefer to take on more risk and allocate their investments into stocks and bonds. Since stocks and bonds tend to move in opposite directions, including both in your portfolio can protect your nest egg during bear markets. For simplicity, let’s take a look a pretty sensible allocation of 50% stocks and 50% bonds and see what kind of returns you might expect based on past performance and see if the 4 percent rule holds up.

Below is a table showing a hypothetical allocation of 50% stocks and 50% bonds derived from historical total returns from the S&P 500 Index and the 10 year Treasury bond from 2000 to 2018. Total returns include both price appreciation and dividends/interest.

Historic stock and bond returns, S&P 500, 10 year treasury yield

Historical S&P 500 and 10 year yield returns

Out of the 19 years shown, there were 7 years in which the market didn’t earn at least 4 percent. This means that your nest egg would have taken a hit in 7 out of those 19 years.

This brings us to the next question.

Will I run out of money if I follow the 4 percent rule?

The short answer is probably not. As long as markets continue to perform at historical benchmark, you should be fine. But historical performance is merely a guideline, not a guarantee. Anything could happen out of your control.

The next great recession could hit and markets crash.
Inflation could turn to hyperinflation and prices go through the roof like in Venezuela.
A serious medical bill may hit you unexpectedly.
You may need a major home repair.
A meteor could destroy the earth....you get the idea.

Some of these problems can be mitigated, but problems with the economy are largely out of your control. So, stressing over future unknowns that are out of your control is really a wasted worry. Instead, focus on what you can control, like properly allocating your nest egg.

Also, the question of whether you will run out of money depends on what you invest in. If you have your money sitting in an FDIC insured savings account earning 2% or less each year and withdraw 4%, you run a high risk of running out of money. Since you would be withdrawing more than you earn, your nest egg would start to diminish.

What are some problems with the 4 percent rule?

Two potential problems with the 4 percent rule are:

1. The 4 percent rule doesn’t account for inflation. Or does it?
2. Withdrawal amounts may fluctuate with market performance.

Potential problem #1: Inflation and the 4 percent rule

This first potential problem with the 4 percent rule is inflation.

In short, inflation means rising prices. Unfortunately for us, the prices of basic needs like food, healthcare, education and housing seems to be going through the roof. While prices of luxury goods like computers, 4K TVs, and other discretionary purchases are falling.

If the cost of living rises and prices skyrocket, you may be tempted or even forced to withdraw more than 4 percent. Doing this poses a real risk of depleting your nest egg.

However, the good news is that any inflation should show up in stock prices. See, just like food, healthcare, and other living expenses, stock prices go up in value too. If inflation is going up, so should stock prices.

Think of it this way, if your portfolio earns 7% per year and inflation runs 2%, your “real” net gain for the year is 5%. So, assuming you withdraw 4%, your “real” net gain would be 1%. But, that may not be enough cushion for most.

Below is a table showing inflation rates since 2000. For each year, you would have to earn at least the inflation rate plus your 4% annual withdrawal just to stay even with rising prices. For example, in 2007 when inflation was 4.1%, you would have to earn at least 8.1% to stay even (4% withdrawal plus 4.1% inflation).

Historical inflation rates, consumer price index, CPI

Historic inflation CPI rates

Potential problem #2: Withdrawals and the 4 percent rule

Another problem with the 4 percent rule is that withdrawals during down years may yield you less income.

Let’s say you started with $1,000,000 in the first year. For simplicity, let’s say you earned 4% which equates to $40,000. Under the 4 percent rule, you would withdraw $40,000 at year end. The net result is that you still have your $1,000,000 at year end.

Now, assume the market declines by 4% the following year. Your year end investment is now worth $960,00. A 4% withdraw from $960,000 equals $38,400, which is short of your $40,000 anticipated withdraw form the previous year. For those without other sources of income outside of your nest egg, this can cause a real strain, especially if inflation causes a rise in living expenses.

However, the opposite can happen when the market is up. If the market were to increase the following year by 8%. Then your $960,000 grows to $1,036,800. A 4% withdraw on this amount would be $41,472. These fluctuations tend to average out over time.

Historically since 1928, the weighted geometric average of a portfolio invested 50% in the S&P 500 and 50% in 10 year Treasury bonds has yielded around 7%. Assuming a 4% withdrawal rate, this would theoretically leave you 3% wiggle room for inflation.

What happens if I retire right before a financial downturn? Will the 4 percent rule hold true?

As mentioned above, stocks can fluctuate year by year. What would happen if you decided to retire right before a market crash? Does the 4 percent rule pose a threat?

Let’s look back to 2000 when the dot com bubble burst and 9/11 caused worldwide financial turmoil followed by a 6 year recovery, then another financial crash in 2008 fueled by the subprime mortgage and banking meltdown.

Where would a hypothetical portfolio of 50% stocks and 50% bonds be today using a 4 percent annual withdrawal rate? Below is a table showing what would happen if you invested $1,000,000 right before the crash of 2000 and withdrew 4 percent each year throughout the market ups and downs.

The 4% withdrawal rate

As you can see from 2000 to 2006, it took 7 years for your nest egg to recoup the losses and recross the original $1,000,000 threshold. Also, take note of the fluctuations in withdrawal amounts year by year.

By the end of 2018 your nest egg would have grown to $1,301,931.

Summary

Here’s a quick summary of the 4 percent rule:

Determine your nest egg needed for retirement by multiplying your annual expenses by 25.
Find an asset allocation matches your risk tolerance.
Use 4 percent as a maximum annual withdrawal rate.
Stay flexible and adapt to potential difficulties like inflation and market fluctuations.

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Conclusion

The 4% Rule: How much do you need to retire?

What is the 4 percent rule?

How much money will you need to retire under the 4 percent rule? The multiple of 25

Expense tracking apps

Let’s assume you’ve reached your target nest egg...What asset allocation should you use during retirement with the 4 percent rule?

Will I run out of money if I follow the 4 percent rule?

What are some problems with the 4 percent rule?

Summary

Author

Archives

Categories

Supercharge Your Retirement: How IRAs Can Mean Big Tax Savings for Tax Year 2024!

Traditional IRAs – Your Partner for Tax Savings Now

Roth IRAs – The Magic of Tax-Free Retirement Income!​

Traditional vs. Roth IRA: Quick Glance​

​IRA Funding – Choosing Your Investment Path​

Coverdell ESAs – Tax-Smart Savings for Education (A Special Mention)​

Simplified Employee Pension (SEP) IRAs – A Big Boost for Small Businesses & Self-Employed​

SIMPLE IRAs – Easy Retirement Savings for Small Employers​

The Power of Tax-Advantaged Growth: IRA vs. Taxable Account​

Your Journey to Tax-Smart Retirement Savings Starts Now!​

6 Financial Philosophies to Live By

6 Financial Philosophies to Live By

Financial Philosophy 1: Avoid DEBT

Financial Philosophy 2: Save, Save, Save

Financial Philosophy 3: Understand the power of compound interest

Financial Philosophy 4: Diversify your income sources...get side hustles!

Financial Philosophy 5: Don’t stress over timing the market

Financial Philosophy #6: Invest in yourself

Conclusion

The 4% Rule: How much do you need to retire?

What is the 4 percent rule?

How much money will you need to retire under the 4 percent rule? The multiple of 25

Expense tracking apps

Let’s assume you’ve reached your target nest egg...What asset allocation should you use during retirement with the 4 percent rule?

Will I run out of money if I follow the 4 percent rule?

What are some problems with the 4 percent rule?

Summary

Author

Archives

Categories

Roth IRAs – The Magic of Tax-Free Retirement Income!

Traditional vs. Roth IRA: Quick Glance

IRA Funding – Choosing Your Investment Path

Coverdell ESAs – Tax-Smart Savings for Education (A Special Mention)

Simplified Employee Pension (SEP) IRAs – A Big Boost for Small Businesses & Self-Employed

SIMPLE IRAs – Easy Retirement Savings for Small Employers

The Power of Tax-Advantaged Growth: IRA vs. Taxable Account

Your Journey to Tax-Smart Retirement Savings Starts Now!