The Four Percent Rule (a.k.a. 4% withdrawal rate or sustainable retirement withdrawal rate) is a general rule of thumb on annual withdrawals from a retirement portfolio which aids in determining whether you have enough money to retire, regardless of your present age. The sustainable long-term retirement withdrawal rates were originally addressed by Bierwirth (1994), Bengen (1994, 1996, 1997), Ferguson (1996), and Cooley, Hubbard, and Walz (1998). The "Trinity Study" then rehashed the work from Coley et al. (1998) in a 1999 publication stating the following: 

Using these findings, many recent analysis have continued to run the numbers to see if the 4% sustainable withdrawal rate is still valid. In most analysis, the 4% rate has held up well for periods up to, and occasionally beyond, 30 years. However, going back to Bengen's original research on the withdrawal rates, there are some serious assumptions that need to be addressed and understood by anyone beginning to consider drawing down on their retirement portfolio, or "nest egg".

When evaluating your retirement portfolio, ​according to Bengen, you may make a first-year withdrawal of 4 percent of your portfolio. Each year that follows, you may adjust for inflation to maintain the purchasing power of your dollars. The problem is, Bengen does not seem to suggest how to "adjust for inflation" with these withdrawals. My assumption- to which I may be incorrect- is that you can take your initial 4% withdrawal, and multiply by the anticipated rate of inflation for the year. You may either Google expected inflation rates, or attempt to calculate them on your own which typically requires you to understand changes in the CPI, as well as have a crystal ball since you take the full year's change in CPI. 

For example, let’s say your portfolio at retirement totals $1.2 million. According to the 4% rule, you may withdraw $48,000 in Year 1. If inflation expects to be 3% next year, you can give your initial $48,000 a 3% raise of $1,440 to equal $49,440 for Year 2, and so on for the remaining 30 plus years. 

Most people will stop right there and assume that they can calculate their level of financial independence simply using their net worth. This is not true! 

​Additionally, many people need to understand the premises that exist that make the 4% 

​Assumption #1 - According to William Bengen, he assumed a balanced portfolio of 50% equities and 50% intermediate term treasuries which are rebalanced. His analysis did prove that up to 75% stocks and as low as 25% bonds would suffice as well. 

Most people do not have this type of asset allocation. To reiterate, Bengen suggested keeping a stock allocation of at least 50%, but no more than 75%, of your overall portfolio. The remaining would be invested in intermediate-term treasuries. Consider that most of you, in fact, do not have every last dollar invested in their retirement portfolio the way Bengen's research suggests. Rather, you likely hold some of your money in cash, CD's, money market funds, and checking and savings accounts that are not exposed to the market which is what makes the 4% rule work. 

The trick is, you need the growth-potential of stocks combined with stability of bonds (especially with dismal interest rates on other savings vehicles) to keep your portfolio alive for a minimum of 30 years. Therefore, every dollar you have outside of this portfolio is best considered emergency or supplementary funds and not used in calculating your financial independence number. 


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Assumption #2 - The funds in which you will be drawing 4% from are in tax-deferred vehicles such as traditional IRA's, 403(b)'s, 401(k)'s, pensions, or 457(b) plans. This is a major misunderstanding in the F.I. community!

The reason this is such a big issue is because capital gains and dividends are not taxed as they continue to grow inside a tax-deferred vehicle. You will thus only be taxed on withdrawals from these accounts which will be taxed as ordinary income, not capital gains or dividend rates. This also assumes that you are of proper age- or met one of the IRS exceptions to early withdrawal penalties- to make your withdrawals after the age of 59 1/2. 

Sure, there are exceptions of withdrawing from retirement funds without penalty for scenarios such as financial hardship, first time home purchase exclusions, and others. However, Bengen did not account for those! Therefore, in order to be valid and effective, the 4% rule was based on your money being entirely in tax-deferred accounts. 

Bengen actually said the following in his paper:

• If the assets had been held in a taxable account, the conclusion might have been different, as the certainty of substantial capital-gains taxes would have to be weighed against the probability of a large stock-market decline, and the loss of the benefit of a step-up in basis upon death. Source

Further, you may not include home equity or other savings and investments outside of stocks and bonds, in the above proportions, when calculating your financial independence number. The reason for this is because the research did not analyze this, therefore we have no idea how it may hold up over time. 



Assumption #3 - You never draw above 4% in any given year on your portfolio. This means if there is an emergency expense in a given year, you need to have either income from another source, or outside savings that are not part of your retirement portfolio to cover them. Further, you may not give any of your principle away since your initial 4% calculations were based on you not reducing your principal in any given year by more than 4%. This becomes a problem if you want to give money to heirs while you are still alive since this will likely put you above the 4% annual withdrawal rate. 

Keep in mind, this information is not designed to scare you. Rather, use it to help guide you into making an informed decision. The main takeaway is that when considering your safe withdrawal rate, you must use accounts that are accessible and tax-deferred (Assumption #2) and able to be invested in bonds and equities with tax-deferred growth (Assumption #1). Further, giving a large piece of your retirement portfolio away as a gift- or other unexpected expenses- likely means you need to return to the drawing board to determine your new safe withdrawal rate. 

• How To Avoid Unhappiness Pursuing FIRE​​

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The pursuit of financial independence, for many, is the holy grail of personal finance. However, a common mistake is often made in pursuing such a financial milestone. Let's take a closer look at where pursuing early retirement and financial independence often goes wrong in the FIRE community. 

Let me first start by saying financial independence is a worthy goal for many.  Personally, I am not yet financially independent but am halfway towards our goal. However, use care when first starting out pursing F.I. as you can quickly lead a life of deprivation instead of enjoying the values of frugality.

Financial independence is loosely set at 25x annual expenses (aka your F.I. number). This requires some initial expense tracking (not budgeting, but tracking) for at least 12 months. You may also look at previous 12 month periods if you anticipate your expenses will reasonably remain the same. Take these expenses for an entire year and multiply them by 25. 

Why 25? This is related to the 4 percent rule of thumb originated from research conducted by William Bengen in 1994. He evaluated 4 percent annual withdrawals from a portfolio with a minimum retirement duration of 30 years. His research concluded the following:

​This research permitted the financial independence community to put an actual number on the pursuit of early or regular retirement. Saving at least 25 times your annual means that your first year withdrawal of 4% is consistent with the total amount of money necessary for the rule to remain in effect. 

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Now, there are a few problems with chasing this number. 

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Problem #1 - Bengen's research assumes you maintain a 50/50 stocks to bonds portfolio, rebalanced annually. For the young folks out there, 50% bonds feels way too conservative!


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Problem #2 - The rule only applies to money held in tax-deferred accounts. This is because your overall portfolio return would be reduced when factoring in capital gains taxes and dividend taxes therefore reducing the longevity of your money if you continue 4% withdrawals. 

Bengen actually said the following in his paper:

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Problem #3 - Your F.I. number is probably bigger than you think since we are not including home equity and largely ignoring taxation. Having an even larger financial independence number is disheartening since your original assumptions were probably based on net worth as opposed to available balance in tax-deferred accounts. This is a very common mistake in the FIRE community!


Problem #4 - Past ​returns are not indicative of future performance. This data was based on historical observations, not future predictions. Just because these 4% withdrawals survived in a 50/50 stocks to bonds portfolio in the past, does not mean the rule will hold up for the future- although I am still personally betting that it will. 
 

​This is the point where attainment of your F.I. number can quickly become pathological. Frugality is not about deprivation and therefore neither is financial independence. However, you can quickly become too consumed with your financial independence status and overall net worth and lose site of the joys of valuing a dollar and practicing frugality consciously. I am not implying that we all need to experience a life of sunshine and rainbows with no hardship along the way. Rather, I am cautioning against allowing money and net worth to rule your world over all else. I have personally made this mistake and do not wish to repeat it nor have others emulate it. 

First and foremost- this is one I have resisted the most- automate your savings. Automating your savings removes the necessity to consciously transfer money into your investible accounts and reduces the likelihood of living in the spreadsheet (see Ramit Sethi's book I Will Teach You To Be Rich for more on this). 

Second, get clear on what matters most to you on this journey. The number is a secondary outcome and should not be the primary driver of your pursuit. Most of us want more freedom to make conscious decisions with what we do with our time rather than being beholden to a toxic work environment or arbitrary rules set forth by our employers. 

Third, remember that their are no hard and fast rules for finances. Be flexible and willing to adapt on this journey. For example, the 4% rule is generally a "rule of thumb" and is not meant to be a guarantee. This withdrawal may actually fail in the future depending on market conditions.

Further, consider if you even need 25 times annual expenses to make a true career or life change. Suppose you had $250k saved and only spent $50k per year. You still have 5 years worth of expenses saved up! This should be more than enough cushion to make a move on some real life changes if you are not happy in your present situation. If you truly dislike what you are doing please do not feel that you have to get to full financial independence before you make a move. Often times, you can begin making radical changes much sooner. If you love your job, this entire paragraph does not apply and you will likely benefit from staying the course in your pursuit.  

Lastly, control what you can control. As much as we like control in our lives, admittedly their are things that are beyond your reach. For instance, take the market conditions. Although the 4% rule worked through previously difficult economic times, again there is no guarantee it will work in the future. Can you really control what the market will do in the future? No. Therefore there is no need to worry about it. Use the 4% rule as a general framework, control what you can control, and be willing to abide by the suggestions above as time goes on.

Best of luck in your journey and remember to keep things in perspective.

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Financial independence- and thereby early retirement for those who choose- is a worthy goal for those seeking to gain back control of their time.  Simply put, financial independence is having enough savings or residual income to cover your expenses for the rest of your life without needing to rely on employment or others for assistance.

Typically, financial independence is thought of as your "retirement age" and not given further investigation by those under the age of 60. Why is this the case? Consider the following societal anchor points for retirement:

• Social Security Age (62 for early retirement and older for standard benefits)
• Full retirement age for a work pension (based on age and/or years of service)
• Medicare age for Health insurance (65 and older)
• Full retirement age for 401(k)'s and other tax-deferred accounts (typically 59 and a half)

The assumption then is that we will need to work until our 60's, at minimum, before we can contemplate early retirement. That is, until we understand that there is actual evidence and analysis that it is possible to retire much sooner than your 60's, although access to the above benefits is likely nil. 

Remember, financial independence is having enough savings and/or residual income to cover your expenses for the rest of your life without needing to rely on employment or others for assistance. Technically, this can occur at any age. 

Financial independence, as well as early retirement, can then be simplified into mathematics based on investments and expenses, not age. A commonly held belief is that age is the single most important variable regarding retirement thus neglecting the most significant variable of all, your nest egg of invested savings. Do not allow the limiting beliefs of friends and family to lead you to the idea that you will also have to work for decades, in a job you dislike, just to catch a few golden years of retirement late in life. Financial independence is all about the math.

Without further ado, let us dig into the numbers of financial independence and early retirement. To calculate your financial independence number, proceed as follows:
[Expected Annual Expenses (in dollars per 12 months) x 25] = Financial independence # (in total dollars)

​To solve for this individual equation, you will need to estimate your expected expenses per 12 months moving forward. This requires some initial expense tracking (not budgeting, but tracking) for at least 12 months. As a frame of reference, you may also look at previous 12 month periods if you anticipate your expenses will reasonably remain the same. If not, factor in recurring upcoming expenses such as increased health care premiums, increased or decreased housing expenses, etc.

Once you have your expected annual expenses, multiply them by 25 as above to determine how much you will need to your investment portfolio for financial independence and early retirement. 

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Why 25 times your expected annual expenses?
​This is related to the 4 percent rule of thumb originated from research conducted by William Bengen in 1994. He evaluated 4 percent annual withdrawals from a portfolio with a minimum retirement duration of 30 years. His research concluded the following:

The overarching theme is that for those who are long-term savers, financial independence and early retirement is not as evasive as we might think. It's merely just one giant math problem.

However, the above is a simple equation and is certainly no guarantee that your money will last forever. That said, consider that most people have no idea that there is actually solid research- as well as a way to calculate- the path to financial independence and early retirement. 

Let this math be your framework moving forward. Understand that the above 4% withdrawal rate has some built-in assumptions and problems that need to be addressed and fully understood before you begin withdrawing your money. I will be highlighting those in another post. My guess is that if this is the first time you are hearing about financial independence and the possibility of early retirement, you likely have some more saving and investing to do before you need to worry about the precise mechanics of how you will withdrawal 4% of your money. 

It is not entirely clear to me why this information is not more widely understood. I do, however, have some theories that I can share.

Theory 1. Our financial advisers and gatekeepers are paid to keep us contributing and investing to long-term programs. The problem with financial advisers largely controlling the dissemination of personal finance information to the public is that it is likely their interests will come before yours (unless you have a "fiduciary" adviser). If your adviser's compensation is based on assets under management (AUM) or load-fees, then their livelihood is based on you continuing to contribute and grow your nest egg. Again, this sounds like a good thing and perhaps it is if you detest the idea of managing your own money- or otherwise have a very complex estate to manage. However, paying higher fees and getting encouragement to continue working and investing for many years beyond financial independence will keep you working longer than you otherwise may have needed.

Theory 2. Most people are terrible savers. Period. 

​Theory 3. New media anchors us to minimum retirement age in our 60's, for all the reasons mentioned already above. 

Theory 4. Our parents, grandparents, or guardians worked forever and thus gave us a similar script with which to framework our own lives.

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Disclosure: This post may contain affiliate links wherein I get a commission if you decide to make a purchase through these links, at no additional cost to you.

Cheapness... a wolf in sheep's clothing.

​Being cheap is very often mistaken for true frugality. Cheapness refers to a state of being consumed entirely by price tags. Cheaper is better and something over a fixed dollar amount, say 100 bucks, is too expensive. Affordability is a less-than-versus-greater-than analysis fixed to a set price amount. 

On the other hand, frugality hinges on conscious spending. There is no absolute dollar amount for frugality. If you find yourself anchored by such a price ceiling you are more likely leaning towards being cheap instead of being frugal. It's alright, there is hope for you yet.

• Do you find yourself skipping a vacation only because you "can't afford it"? 
• Are you avoiding going out with friends because you are worried about your account balance?
• Have you ever resisted purchasing a replacement for something that is clearly broken or operating poorly for a long time?
• Have you ever stared aimlessly at a price in the grocery store just to figure out the price per ounce?
• Do you have hopes and dreams of traveling to a particular place but won't do it because you have to hit $100,000 in savings before year's end?
• Only making minimum payments on a high interest loan (anything above 3% in my opinion) because you find it too difficult to pay it down more aggressively?
• Purchasing something that you clearly don't need only because it was on sale?

​The above questions are designed to get you thinking about price vs. value. If the first thing you think of is price when assessing the above questions, you likely have a cheap mindset. A cheap mindset is often described as being very fixed, rigid, possessing an enormity of limiting beliefs.

Don't get me wrong, the goal is certainly to save and invest as an aggressive pursuit towards financial independence. However, years of deprivation and missed life experiences are not.

Frugality is a central tenet of my writing. Value-driven conscious spending and saving towards a worthy pursuit. Yes, financial independence is important but, it's not more important than your health and happiness in the pursuit thereof. 

The first post ever published on this blog was an effort to define frugality. The three main pillars of frugality are value, awareness, and freedom.

Ask yourself the following questions:

• Do you value experiences over prices?
• Are you aware of your present financial situation and long-term goals?
• Do you truly have the freedom to decide, even on the smallest scale, what you want for your life?

If the answer is no to any of the above don't panic, it just means you are operating from a poor mindset, regardless of how much money you have in the bank. Things can and will change. So where do you start?

By reading this post, you have already started. Educate yourself and do not be afraid to question your existing money mantras. Do you believe that attaining a high net worth is only for liars and cheaters? Does the thought of saving and investing evade your thoughts entirely? Is it possible that you have missed out on life experiences because of a deprivation mentality?

If there is a vacation you want to go on, wedding that you'd love to attend, or any other experience that you would cherish and value, start figuring out how to make it attainable. Frugality is not about saving costs at every corner but rather finding value in every dollar you spend. Long-time personal finance author Vicki Robin wrote about life energy in her renowned book Your Money or Your Life. Think of your dollars as life hours. How many "life hours" of your day job will it take in exchange for your purchase. If you decide that two weeks worth of work is a worthy trade for a new dishwasher then by all means, go for it. In contrast, aimlessly spending $200 on shoes or $600 on a television you don't need in exchange for several hours at work hardly seems like a worthy ideal.

Most importantly, don't be afraid to assess your spending. So many of us have poor financial outlooks because we don't even take the time to look at it or are otherwise fearful that it might confirm our existing limited beliefs. It's time to buck that trend and get honest with how terrible you are at assessing true value in life. Researchers have continuously found that social interconnectedness and experiences are high-value activities in terms of life enjoyment. With that in mind, it seems ridiculous to miss out on a trip with friends or family just because you can't afford it. Rather than traditional budgeting, instead focus on saving that amount by working more or spending less for a short period until you have saved the necessary funds for the upcoming expense. Remember, personal finance is best handled with an open mindset and ability to adapt and adjust when the situation calls for it. 

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Certainly tax planning is a dreaded topic for nearly everyone. Yet taxes are mistakenly overlooked when considering overall annual expenses.

Taxes on income, property, and consumer goods adds up to a significant enough total to likely be the biggest expense category for any given household. After accounting for federal, state, and local taxes, further including FICA taxes, you will take home significantly less than you originally expected to be paid.

​Consider however, that these taxes can be reduced through some very simple strategies that impact your financially independent future as well. Reducing your taxes now (legally of course) will keep you in control of a greater percentage of your dollars

Nerdwallet posted a solid article on 12 tips to cut your tax bill. 

Some of the most common strategies involve contributing to employer-sponsored retirement plans, qualifying traditional IRA contributions, and contributions to health insurance premiums and HSA's. Charitable donations are also valuable ways to positively impact the community and receive a tax deduction in the process.

Let's imagine a hypothetical example of Mr. and Mrs. Gibson. The Gibson's have an expected total household income of $150,000 for the year 2021. This firmly puts you in the 22% federal tax bracket (again, as of 2021).

In this example, keep in mind that the upper limit for the 12% tax bracket is $81,050. This means that every dollar over that $81,050 (12% tax bracket upper limit) will be taxed at 22% instead of 12%, a 10% difference. This is how a progressive tax system works.

So in our hypothetical example, how would the Gibson's save 10% on federal taxes in this year?

• If this couple took the 2021 standard deduction of $25,100, they would fall to $124,900 in federally taxable income
• If they further contributed to 401(k) or 403(b) plans up to the maximum amount of $19,500 per individual, which is $39,00 total for this household. This would then further reduce their federally taxable income all the way down to $85,500.
• Further, if their household health insurance premiums totaled $4,800 for the year ($400/month), they would drop to a federally taxable income of $80,700. 

​In this hypothetical example, all of their earnings above $81,050 would have been taxed at 22% up to their the full $150,000. When accounting for all of their deductions above, the Gibson's would have completely avoided the 22% tax bracket thus keeping more of their money working for them in retirement vehicles earning compounded growth.

Keep in mind that NONE of this is tax advice and you still need to consult with a financial professional if you do not feel comfortable planning on your own. This is for educational purposes only.

In the above fictional scenario of the Gibson's they would be able to use their federal tax savings to make greater retirement contributions while they are young, thus dramatically improving the power of compound interest over time.

Imagine year after year, as the tax rules change, learning about ways to avoid higher taxation and keep more of your money working for you instead of being handed out in taxes. These are perfectly legal strategies that are published in our tax code, but the rules do change often. For that reason, if you do not have the stomach to keep abreast of U.S. tax code, you must consult with a financial professional such as a certified public accountant (CPA) as well as a tax attorney who specializes in your state.