A rule of thumb is defined as a broadly accurate guide or principle. They are easy to understand and simple to apply. Because of this, a rule of thumb makes you more efficient in decision making, which is key to building wealth.
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Let's look at a few 'rule of thumb' examples:
In financial independence circles there are 2 "rules of thumb" that rule them all. The 25X Rule & the Four Percent Rule.
The 25X rule, like others, is quite simple. It's simply this...once your investment portfolio is 25 times your annual expenses, you can say peace out to 9-to-5 and leave cubicle hell forever -- you're financially independent!
For example, if you plan to spend $50,000 per year in retirement, you should have a minimum of $1.25 million in investments. $50,000 is 4% of $1.25 million.
With any rule of thumb, you need to determine if it is right for you. Because the 25X Rule doesn't take age into account, it may not be as applicable to younger retirees. If you plan to retire in your 30s, your money needs to last much longer than someone retiring in their 60s. Therefore, you may need to play it safe by saving more than 25X. For many, that means following the 33X Rule, which requires investments equal to 33 times planned annual expenses in retirement.
What do we do? Because we are in our 30s, and because we want to avoid even the slightest possibility of going broke, we follow the 33X rule.
Here's a quick guide for the amount needed to retire. Keep in mind that while your home should be counted as part of your net worth, it does not count toward the 25X or 33X.
Annual Expenses | Investments at 25X | Investments at 33X |
---|---|---|
$20,000 | $500,000 | $660,000 |
$30,000 | $750,000 | $990,000 |
$40,000 | $1,000,000 | $1,320,000 |
$50,000 | $1,250,000 | $1,650,000 |
$60,000 | $1,500,000 | $1,980,000 |
$70,000 | $1,750,000 | $2,310,000 |
$80,000 | $2,000,000 | $2,640,000 |
$90,000 | $2,250,000 | $2,970,000 |
$100,000 | $2,500,000 | $3,300,000 |
The 4 Percent Rule is used to determine how much a retiree can safely withdrawal from their investment portfolio each year without running out of money.
The 4 Percent Rule states that a retiree can safely withdrawal 4% of their investment portfolio's value (at time of retirement) plus inflation every year going forward. Hence, why it is recommended to save at least 25X our planned annual expenses.
If you want to be more conservative like us, we changed the 4 Percent Rule to the 3 Percent Rule, requiring an investment portfolio at 33X our planned annual expenses.
There is much debate surrounding the 4 Percent Rule. Many financial professionals feel that 4% is too aggressive considering we're living longer, healthcare costs are increasing, etc. However, almost all agree that a 3% withdrawal rate is near bulletproof.
The moment your investments reach $1 million, the 4 Percent Rule states that you can withdrawal $40,000 in year 1, $40,000 + inflation in year 2, year 2 withdrawal amount + inflation in year 3, and so on. At 2% inflation, a retirement on a $1 million investment portfolio would look like this.
Year | 4% Withdrawal Rate | 3% Withdrawal Rate |
---|---|---|
Year 1 | $40,000 | $30,000 |
Year 2 | $40,800 | $30,600 |
Year 3 | $41,616 | $31,212 |
Year 4 | $42,448 | $31,836 |
Year 5 | $43,297 | $32,472 |
Year 6 | $44,163 | $33,122 |
Year 7 | $45,046 | $33,784 |
Year 8 | $45,947 | $34,460 |
Year 9 | $46,866 | $35,149 |
Year 10 | $47,803 | $35,852 |
A 4% withdrawal rate is designed to provide steady & consistent income stream to the retiree. It also does so in a way that maintains an account balance large enough to keep income flowing for as long as needed.
Keep in mind that a side hustle is a great way to reduce your withdrawal rate in early retirement. Assuming a 4% withdrawal rate, every $1,000 earned in retirement is equivalent to an additional $25,000 in investments. At a 3% withdrawal rate, every $1,000 is equivalent to an additional $33,333.
I know you're probably thinking, that's great, but how can I be sure? How can I have confidence that once I hit "my number" I'm safe to retire forever? There have been multiple studies done that have backtested and simulated all conceivable outcomes, and they have all landed on 4% as a safe withdrawal rate. The most famous of all studies is the Trinity Study.
I won't attempt to go into the technicals, but if you'd like to read more, there are additional articles below.
In the comments below please let me know what safe withdrawal rate you plan to use in retirement and why.
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