Why do we make things so complicated? Take retirement accounts for example. It seems like a
simple concept. Enable people to save money tax-deferred during their working years, and then tax the investments when they are withdrawn from the account in retirement.
Yet our beloved government has managed to complicate this simple concept. Let's start with the types of retirement accounts. If you think there is just a 401k or IRA, think again. Here's just a partial list:
• Traditional 401k
• Roth 401k
• Self-Directed 401k
• Safe-Harbor 401k
• Tiered Profit Sharing 401k
• Simple 401k (my personal favorite)
• Individual Retirement Arrangement (IRA)
• Roth IRA
• SEP IRA
• Inherited IRA
• Simple IRA
And that's just a short list. I haven't even touched 403b plans, 457 plans, or defined benefit plans.
The complications go far beyond the type of retirement plans. There's the question of whether traditional IRA contributions are deductible. Should you invest in a Roth or traditional retirement account, or both? Many are asking if they should convert traditional retirement account funds to a Roth account. Part of that question brings up the Backdoor Roth. And forget about calculating your Required Minimum Distribution on your own.
In the midst of all this complexity, today let's talk about a very simple rule. I call it the 25x Rule to Early Retirement. Here it is. As a general rule, you need to save 25 times your annual expenses (not salary) to retire. Once you've achieved that milestone, you are financially free.
Let's look at an example. If you spend $75,000 a year, you'll need a nest egg of $1,875,000 to retire. You'll notice that I've completely ignored other sources of retirement income, such as social security. If you are retiring early, you won't have access to social security, at least not at first.
If you do have other sources of income, however, it's easy enough to make the adjustment. In our example, let's assume our fearless early retiree will receive $25,000 a year from an annuity. In that case, their nest egg need only cover $50,000 a year. Using our 25x rule, that brings down their required savings to $1,250.000.
Now let's turn to why this rule works. The financial goal of retirement is to make sure that we die before we run out of money. Financial planners have a more subtle way of stating this stark reality. They call it longevity risk. That's the risk that your money will run out before you do. Putting aside the fancy words, the goal remains the same--making sure we expire before our money does.
The theory behind the 25x rule is another rule--the 4% safe withdrawal rate rule-of-thumb. According to the 4% rule, a retiree can withdraw 4% of their investments in the first year of retirement. In subsequent years, they can then increase the amount by the rate of inflation. At this withdrawal rate, the theory goes, the retiree has a reasonable chance of dying before they run out of money. The 4% rule is covered in detail in the Trinity Study.
I'm working on another article that explores the Trinity Study in more detail. For our purposes, however, there are three very important things to keep in mind about the 4% rule:
1. It's not a guarantee. Experts have backtested the 4% rule and found that it works most of the time. A very bad market in the first few years of retirement, however, could spell disaster for any retiree.
2. Asset allocation matters. According to William Bergen, the father of the 4% rule, your allocation to stocks should be no less than 50% and closer to 75%.
3. The assumptions do not account for investment fees. Pay an advisor one percent or more a year to manage your investments and you'll need to lower the 4% rule accordingly.
https://www.forbes.com/sites/robertberger/2017/02/23/the-25x-rule-to-early-retirement/?nowelcome=1#22f8eb9d6faf
