The 4% withdrawal rule is a common framework for people who want to make sure their retirement savings last. The strategy entails withdrawing 4% of your savings during your first year of retirement, then adjusting that figure for inflation in subsequent years.
However, this rule can eventually clash with required minimum distributions (RMDs) that the IRS requires people start taking from traditional retirement accounts after they turn 73. Here’s what you need to know.
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The potential tax trap
RMDs count as taxable income, and you must take money out equal to a percentage of your nest egg. Your RMD amount is based on your total account balance and an IRS life expectancy factor based on your age. Traditional individual retirement accounts (IRAs) and 401(k)s have RMDs, but Roth accounts don’t.
Your RMDs can go up as you age, which may make it challenging to continue withdrawing just 4% throughout your retirement. But also, larger RMDs typically come with a larger tax bill.
When determining your withdrawal strategy, tax planning is key.
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Strategize to minimize your RMD taxes
One approach to dealing with RMDs and their associated taxes is to start withdrawing from your traditional 401(k) and IRA plans before you turn 73. You can pull from these first instead of Roth accounts, since RMDs don’t apply to Roth accounts.
Some people opt for a Roth conversion, which entails moving money from a pre-tax retirement account to a Roth account that is not subject to RMDs. Any withdrawals from a Roth retirement plan are not taxed, and your money can grow for longer.
You can also do qualified charitable distributions to give your money to causes you support while reducing your taxes.
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Adapt your withdrawal strategy over time
The 4% rule won’t work for everyone, and the right strategy for you may change over time. Morningstar determined that 3.3% was a more safe starting withdrawal rate in 2021 (“assuming a balanced portfolio, fixed real withdrawals over a 30-year retirement, and a 90% probability of success”). The firm raised that to 3.8% in 2022 and 4% in 2023, then brought it down to 3.7%. Their latest estimate is a 3.9% starting withdrawal rate.
But Morningstar says there are potential benefits to more flexible strategies too, such as not fully adjusting your withdrawal rate for inflation after annual portfolio loss. "For example, a person following this strategy wouldn’t increase withdrawals after the 2022 bear market, despite the large jump in inflation that occurred at the same time," the Morningstar researchers wrote.
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Another potential strategy is to take withdrawals in line with RMDs.
"Retirees can use the same framework that underpins RMDs from IRAs," the researchers wrote. "Divide portfolio value by life expectancy to calculate an appropriate withdrawal rate."
