The right way to tap into your 401(k)

The 4 percent withdrawal rule has been misinterpreted and misapplied by retirees. Our expert sets things straight.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I often hear that you shouldn't withdraw more than 4 percent a year from your 401(k) after you retire. But if your account is growing at 8 percent a year and you take out only 4 percent, wouldn't your account value just keep growing?

Seems to me you should be able to withdraw 8 percent annually and never need to touch your principal. What am I missing? - Gerald S., Sacramento, Calif.

Answer: You've heard of that parlor game where a group people sit in a circle and one of them whispers a sentence like "Forest Whitaker's performance in 'The Last King of Scotland' was a tour de force" to the person on his right. It goes around the circle and ultimately morphs into something like "Helen Mirren toured the forests of Scotland while performing her role as the Queen of England."

Well, something similar is going on with the 4 percent withdrawal rule. As a result, the rule is flat out misunderstood and completely misapplied. So let's see if I can clear up some of the questions you (and many others) have about it.

To begin with, the idea behind this rule of thumb is not that you withdraw 4 percent of your portfolio's value every year of retirement - the target refers to just your initial withdrawal. So, for example, if you retire at 65 with $500,000 in savings, you would withdraw $20,000 (4 percent of $500,000) that first year.

Then in subsequent years you will boost withdrawals to keep up with inflation. After all, if inflation goes up by, say, 3 percent a year, then all the goods and services that cost you $20,000 today would cost you a bit over $31,000 in 15 years. If you continued to draw only $20,000 from your savings, in 15 years your purchasing power would fall by about a third and your standard of living would decline.

So to maintain your purchasing power, you would take that initial 4 percent withdraw amount and increase it by the inflation rate each year. So if inflation were running at 3 percent a year, you would draw $20,600 from your savings the second year, a bit over $21,200 the next year, almost $22,000 the next and so on.

This strategy also provides some stability as far as budgeting is concerned.

Okay, let's now take a step back and think about what's going on with your savings in retirement. Essentially there are two opposing forces acting on your savings.

On the one hand, the return your nest egg earns is pushing its value up. At the same time, however, the amount of money you withdraw (which is increasing each year) is pushing your nest egg's value down.

Now, if you could really count on getting an 8 percent return each and every year and if you could be sure that inflation would stay under control, then your portfolio should easily be able to handle that 4 percent initial withdrawal plus inflation adjustments for the rest of your life.

But here's the rub: If your nest egg consists of a blend of stock and bond mutual funds, it's not going to earn 8 percent (or any other return) like clockwork year after year. You'll have some years in which you earn more, some less - and there may be years in which your portfolio loses money. Similarly, inflation may surprise everyone and be much higher than it has been.

If you run into a big market setback, especially early in retirement, then you could be in a tough situation, much like the people who retired in early 2000 when stocks began a long slide that lopped off nearly half of the market's value.

The problem is that your nest egg would be hit with a double whammy. Its value has already been decimated by the market downturn. And at the same time, you're reducing the balance further by making withdrawals. That double hit makes it harder for your portfolio to recover even when the market revives because there's less capital to take advantage of rebounding returns. If inflation picks up at the same time, the situation would be even worse because your withdrawals would also be expanding.

To get a handle on these uncertainties investment advisers typically turn to what are known as "Monte Carlo" simulations. Basically, they run thousands of computer simulations to see how your portfolio might hold up under different scenarios.

These computerized simulations can't give you a guarantee of how the future will unfold. After all, they're largely based on probabilities calculated from what happened in the past. Still, these simulations can at least give you a decent sense of a range of possibilities of how things might work out.

And what these simulations generally show is that if you want a high probability - say, 80 percent or so - that your money will last at least 30 years, then you should limit that initial withdrawal to about 4 percent of your portfolio's value.

If you're willing to go with less assurance that your money will last that long, then you can increase that initial withdrawal, perhaps to 4.5 percent or 5 percent.

Similarly, if you don't feel your portfolio has to last at least 30 years - say, you don't retire until you're in your 70s - you can start with a higher initial withdrawal.

Your investment strategy also plays a role in determining your nest egg's longevity. As a general rule, keeping a higher percentage of your savings in stocks reduces the odds you'll run out of money and increases the chance that your nest egg could actually grow in retirement.

That said, even adopting a very aggressive mix - 80 percent or more in stocks - can't assure that you'll be able to sustain a very high initial withdrawal rate for a long time, say, more than 6 percent for 30 or more years.

The reason is that loading up with stocks increases the volatility of your portfolio, which increases the chance of running into one of those gut-wrenching setbacks that are so hard to recover from. One of the virtues of a modest withdrawal rate like 4 percent is that your assets have a good shot at lasting a very long time even if you invest pretty conservatively.

It's important to remember, of course, that whatever withdrawal rate you choose, it's not as if you're locked into it for the rest of your life. You can always make adjustments.

For example, maybe you start with a 4 percent initial withdrawal rate, but find that you want to splurge a bit early in retirement, take some extra trips or vacations while your health is still good and you can really enjoy them. That's okay. You can always pare your withdrawals a bit in subsequent years, perhaps even work part-time so you don't have to adjust your spending too much.

Or perhaps you may find that your investments are doing so well that you can easily afford to pull more money out of your nest egg. That's fine too. You don't want to be so security conscious that you live like an ascetic so that your heirs can live like kings.

Just remember, though, that given today's life expectancies, retirement can last a very long time. So even though things may seem largely under control, it's always possible that you could run into unexpected expenses in the future. Or expenses that you know are coming could be much higher than you expect.

The cost of health care as you age is definitely a wild card.

If you want to get a sense of how long your savings might last at different withdrawal rates, you can go to the Retirement Income Planner at T. Rowe Price's site. I encourage you to try a variety of scenarios, changing the amount you withdraw, your investment strategy and the length of time you expect to live in retirement.

I also recommend that after you've retired you go through this exercise once every year or so (or have an adviser run similar scenarios for you). You may very well find that after, say, a decade in retirement your portfolio's value has grown rather than shrunk. In fact, that's very likely if you start with an initial 4 percent withdrawal rate and you don't hit a bad patch in the market early on after leaving your career job.

Of course, as we saw in the stock market's gyrations last week, the market can also turn against you rather suddenly. So far, that setback hasn't been very severe. But you never know. So it's better to keep tabs on the health of your nest egg on a regular basis and make small adjustments if needed than to assume things are going swimmingly only to suddenly find that your savings have virtually evaporated.


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