The thought of outliving your retirement savings is enough to keep anyone up at night. That’s why it is crucial to stick to a proven system when deciding how much cash you can comfortably withdraw from your nest egg annually without putting yourself at financial risk. One popular approach to solving this problem is the four percent rule. Many people have heard about the four percent rule of thumb, but most don’t completely understand what it means or how to make it work for them.

What Exactly is the 4 Percent Rule?

The 4 percent rule became a standard retirement strategy after William Bengen, a financial advisor, conducted a study in 1994. Bengen's research used historical stock market data from 1926 to 1976. It concluded that regardless of the market's performance, taking out 4 percent from a balanced investment portfolio will only partially deplete available funds for at least 33 years, much longer than the typical retirement. Since the data range Bengen chose includes two severe market downturns, it is generally believed this money management system is safe. The rule is also known as SAFEMAX because it is the maximum amount that can be safely removed from a portfolio. 

Bengen later increased the safe percentages from 4 percent to 4.1 percent if you have to pay tax on withdrawals and 4.5 percent if you don't. Still, most people continue to call the strategy the 4 percent rule and use the original 4 percent when calculating their withdrawals.

Although the four percent rule is a popular retirement strategy and works for many people, it may not be suitable for everyone. Before adopting it, you need to be aware of three very important caveats. 

Three Important Things to Know About the 4 Percent Rule

1. You Have to Practice Discipline

People who choose to follow the 4 percent rule will have to resist the urge to splurge when the market is doing well. This is particularly difficult when you are getting returns that far exceed 4 percent year after year and feel that you are cheating yourself by limiting your withdrawals. Remember that what goes up must come down, and the 4 percent strategy is for the long haul. 

2. Certain Types of Portfolio May Not Fit

The data Bengen used for his study was based on the market's overall performance. That means that if you have about 60 percent invested in low-risk stocks such as an index fund and 40 percent in bonds, then the 4 percent rule should work over the long term. On the other hand, if you hold a lot of high-risk investments, you are in a much more precarious situation since a downturn may decimate your portfolio, and you may never be able to make back the money you lost. 

3. Be Aware of the Required Minimum Distribution Penalties

For some investments, such as IRAs, 401(k)s, and others, you may have to withdraw a minimum amount per year or face a substantial excise tax of 50% of the required sum you do not take out. The date when these minimum distribution penalty requirements go into effect depends on the type of investments when you retire and your current age. You can find more specifics on the IRS website. This may mean that you may have to take out more than you planned in some years to avoid the penalty. 

You only get one shot at preparing for retirement, and maybe the 4 percent rule is not your best option. A qualified financial advisor can help you set up a good retirement plan that considers your lifestyle, goals, and financial means.