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Early Retirement Withdrawal Strategy

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early retirement withdrawal strategyWhen you’re young, you don’t really think much about withdrawal strategy. At 41 and semi-retired, I’m still focusing on accumulating. That’s why I haven’t written much about withdrawal strategies on Retire by 40. Last week, we posted an article about investing a lump sum in midlife. That got me thinking about withdrawals. It will be helpful to Julie and to us as well. Let’s go over a few standard withdrawal strategies first and then see if we can find something that will work for us.

The 4% Safe Withdrawal Rate

You probably have heard of the 4% Safe Withdrawal Rate. Basically, it’s been shown that your portfolio has an excellent chance of outliving you with this method. At the beginning of your retirement, withdraw 4% from your portfolio. Then increase the withdrawal amount to account for inflation rate annually. You should have 50-75% of your nest egg in equities to increase the chance of success.

The nice thing about this method is that the amount of money you can withdraw each year is predictable. It’s also simple so you don’t have to think too much about it. The risk is that you might retire right before a prolonged downturn in the stock market. In that case, this method will deplete your nest egg too quickly. Also, the stock market might not perform as well in the future as the past. If the stock market doesn’t grow like it has in the past 60 years, then 4% withdrawal rate might be too high.

The Constant Percentage Withdrawal

A more conservative withdrawal method is to withdraw from your portfolio at a constant percentage. I guess 4% to 5% would be pretty good here. The difference from the previous method is that your withdrawal amount will fluctuate from year to year. You’ll have less money to spend during the down years and more when the economy is good.

The big advantage here is that your portfolio should get through the bear markets without being depleted too much. The risk is the amount of withdrawal is dependent on portfolio growth. If your portfolio grows, then you’ll be able to deal with inflation. On the other hand, if your portfolio stagnates, then life will be more difficult due to inflation.

The Variable Percentage Withdrawal

Here is an interesting one from bogelheads.org – the Variable Percentage Withdrawal method. This spreadsheet figures out what percentage you can withdraw depending on your age, the projected time in retirement, and how the market performs. First you figure out your life expectancy. You can probably use your parents’ ages at death + 10% or something like that. So if you plan to retire at 65 and project 20 years in retirement, then you can start off withdrawing 7% and gradually increase the withdrawal rate as you get close to 85.

The nice thing about this method is that you won’t run out of money as long as you don’t outlive your projection. If you live longer than expected, then it’s going to be a tough few years at the end.

Dividend Only

Here is a method for the few people who can reach financial independence before retirement age. If your cost of living is lower than your dividend and other passive income, then you’re golden. Your nest egg will stay intact and you’re guaranteed to never outlive your money. Of course, this is a difficult achievement and only a small minority of the working population will ever get there.

Early Retirement Withdrawal

Figuring out the right withdrawal rate is a big challenge for early retirees. This is because we’ll have many more years to spend in retirement. It’s also more difficult to project how long you’ll live when you’re 41. I think if you retire before 55, then you will have to be more flexible about withdrawal. You don’t want to rigidly follow one of these withdrawal strategies. You need to reevaluate your finances every year and see how much you should withdraw.

The good thing about early retirement is that you’re still young. You can work part time, become a landlord, consult, or find other ways to make extra income. You don’t have to quit working after taking an early retirement. Here is my withdrawal plan for example.

Age 40 to 55: We’re not planning to withdraw much at all. I will work part time. Mrs. RB40 will continue to work full time for a while and might cut down her hours in a few years. During this period, we don’t need to withdraw from our nest egg and we will continue to add more to it every year.

Age 55 to 65: This will be a crucial period for us. Mrs. RB40 will probably retire full time here. We’ll have to purchase our own health insurance and we’ll probably travel more. These things will increase our annual expense. Hopefully, our home will be paid for by this time and that should offset the increased cost a little bit. It’s still a long way off so it’s tough to compute right now. I’m guessing we can withdraw 5% from our portfolio every year during this period. It’s dependent on how much we have in our portfolio by then, of course.

Age 65 to 75: I think this period should be fine financially. We’ll qualify for Social Security benefits and Medicare at this point. That should help us with our expense and we should be able to decrease our withdrawal rate a little. We’ll probably cut down on traveling because it’s just not as much fun as you get older. I’m guessing 3-4% withdrawal rate during this period.

Age 75 to 85: I’m not sure here. We probably need to withdraw more of the portfolio due to the inevitable health issues that will crop up.

It’s tough to think about withdrawal rate when you’re young, but it’s still good to touch on it once in a while. It’s nice to know that the 4% withdrawal rate still holds up even with the recent financial crisis. (Updated Trinity study.) The variable withdrawal rate is pretty interesting too. Anyway, the key to early retirement withdrawal is to be flexible. If the stock market enters a prolonged downturn, then you might need to cut back a bit so you don’t have to withdraw as much during those years. Working part time is also a great option for retirees who needs a little extra income.

I’m interested to hear from full retirees to see what method you use. Please share your experience with the younger folks here.

Image credit: flickr by tpholland

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Joe started Retire by 40 in 2010 to figure out how to retire early. He spent 16 years working in computer design and enjoyed the technical work immensely. However, he hated the corporate BS. He left his engineering career behind to become a stay-at-home dad/blogger at 38. At Retire by 40, Joe focuses on financial independence, early retirement, investing, saving, and passive income.

For 2018, Joe plans to diversify his passive income by investing in US heartland real estate through RealtyShares. He has 3 rental units in Portland and he believes the local market is getting overpriced.

Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help every investor analyze their portfolio and plan for retirement.

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{ 28 comments… add one }
  • Jon February 23, 2015, 4:56 am

    My wife and I are only in our 30’s and haven’t come up with a plan yet as to our retirement withdraw strategy. The goal would be to have our expenses low enough to basically live off of the income. But as you said, this is not feasible for most. In the end will be probably fall in the constant withdraw percentage group. I think we will both be “working” part-time while we are retired and the income from that should allow us to pull out the same amount of cash every year from our portfolio.

    • retirebyforty February 23, 2015, 10:19 am

      I like the working part time option too. I really don’t want to hang out at home all day. That’s what I tend to do when I’m not busy. It’s nice, but it’s not very productive. The constant percentage withdrawal sounds better to me than the 4% SWR. It’s a good way to go through the bear markets with minimal impact. Of course, we’d have to tighten our belts during those years, but I think that’s doable.

      • Dividend Growth Investor February 24, 2015, 7:23 am

        I am with Dividend Mantra here – expecting to live entirely off dividends some day ( or at least have the option to). Dividends are always positive, the amount and timing of dividend payments is predictable, they are very stable, usually grow above the rate of inflation. Dividends are paid in cash, and thus I do not have to sell anything to live off of.

        Selling chunks of my portfolio seems risky to me, since I would have to get timing of retirement right (don’t retire prior to a major bear market), and have to retire during a period of time when stock prices grow faster than the rate of decumulation.

        If you think about it, the study behind the 4% rule used data from a time when dividend yields were closer to 4%. Thus it made sense to “spend” 4% of your portfolio, since this 4% came from dividends which constantly replenished your stash of cash. These days, with yields on indexes that are less than 2%, you have to sell chunks of your portfolio to live off.. That sounds risky, and is akin to market timing..

        The goal of a retiree is to stay retired. I would never want to focus on a strategy that could potentially deplete my portfolio since I do not know how long I am going to live.

  • RetiredToWin Alex February 23, 2015, 5:03 am

    I retired earlier at 53. At that point, I had a pot of invested money in a tax-deferred IRA and another pot in a regular taxable account. All my IRA holdings were — and still are — in high-yield dividend stocks, while the taxable account was in cash and good quality corporate bonds. And here is what I did with that.

    I let the IRA account continue to grow via reinvested dividends, while I drew down the taxable account. I calculated I had enough of the taxable account money to cover the 9 year period before I turned 62. At that point, I could begin collecting Social Security and start withdrawals from my IRA account.

    At 67 now, thanks to a “frugality campaign” that reduced my basic living expenses by 42%, I am able to cover those basic living expenses and more just with my Social Security payouts. This is allowing me to withdraw dividends only from my IRA account, and still end up with a very, very nice pool of discretionary money to spend on wants over and above my basic living expenses.

    The real key to the whole strategy, mind you, was not so much in the particulars of the withdrawals but in the frugality campaign that lowered my budget needs so substantially.

    • retirebyforty February 23, 2015, 10:23 am

      Thank you for sharing! Frugality is a great tool for early retirees. How did you reduce your cost of living so much? 42% is a huge. I don’t think we can reduce that much unless we move to a much more affordable part of the country. Portland and all the other bigger west coast cities are getting too expensive.

      • RetiredToWin Alex February 23, 2015, 8:24 pm

        That 42% reduction in basic living expenses was accomplished one budget line at a time. What I call “budgeting by exception.” Other folks may call it budget optimizing. Whatever you call it, I did it continually and serially over a couple of years (and still do, actually). You name it, I found a way to have it for less or not need it at all.

        But, yes, one of the final “coup de’grace” cost reduction moves was to sell the house in the high cost of living area and replace it for a lot less in a more reasonable cost of living area. (Don’t discount relocation; it could really improve your life.)

        Since you’ve asked, all the gory details of my basic living expenses are detailed in one of the currently featured posts in my blog. And a post detailing the 42% reduction is close to finished. (Apologies for the shameless self-promotion.)

  • Dave in Sunny FL February 23, 2015, 5:33 am

    The actual rate of withdrawal is only a small component of a “decumulation” strategy. The more important elements, I think, are the composition of your nest egg (stocks, bonds, real estate, royalties); and the order in which you deplete the various accounts.

    The depletion order depends on tax efficiency. When you have other deductions, you can match them against sales of appreciated assets from your tax-deferred accounts. You also need to look at how mandatory distribution rules (which do not apply to Roth IRAs, thankfully!) affect your tax bill. All of this is many years in the future for me, so I’m going to let the boomers experience this and sort it out before I try to figure out this issue.

    The 4%, 3%, etc. stuff is too one-size-fits-all; as is the income replacement calculation. If a couple maintained a large income to support five children, the couple doesn’t need to replace 70-85% of income for just the two of them. If someone obtains a $10 million nest egg by diligent saving, why should they expect to need to withdraw $400,000 a year for living expenses?

    The biggest danger to retirement funds lasting a lifetime is the danger of large numbers and underestimating the length of retirement. Just because you have a nest egg that’s worth a few hundred thousand dollars, that won’t last indefinitely if you don’t take out a pencil and run the numbers for what it’s going to cost you to live (accounting for dreaded inflation!), and figure on living several years longer than your most long-lived parent.

    The composition issue is of a bit more interest to me. I don’t like the old “100 minus your age” standard to determine the percentage investment in stock. I like the new research on reducing your exposure to stocks gradually as you reach retirement, then increasing it afterwards. Think about it like this: you have financial capital (your investments) and human capital (your capacity for labor); the combination of which must sustain you for the length of your life. As your human capital winds down, you want to be most protected against a drop in your finances, because you still have a (hopefully large) period of years left to pay for. As the years dwindle, you turn the risk on the financial capital back up.

    • retirebyforty February 23, 2015, 10:28 am

      Hi Dave, thanks for your input. It’s tough to do the calculation when it’s 10 or more years out. I guess the younger folks should just focus on accumulating and diversifying the tax baskets. We can worry about withdrawal a bit later.
      I came across that new research too. I need to look into it further. It seems like a one size fit all approach too. It might work for most people, but probably not for me. Experienced investors can probably figure out their own approach to the composition question.

  • Justin @ Root of Good February 23, 2015, 6:01 am

    Great summary of the options!

    I’m going with some variation of the variable withdrawal rate. I looked at 5% of portfolio balance each year and it gives way more spending than we’re doing now, yet still retains a barebones budget in the worst years (which I could supplement with some cash that sits outside of our main investment account).

    Whatever option an early retiree chooses, I think it makes sense to stay flexible with regards to spending.

    • retirebyforty February 23, 2015, 10:29 am

      Staying flexible is the way to go. 5% sounds pretty high when you may have 50 years left in retirement. Are you worried about running out of retirement funds?

  • kyith February 23, 2015, 7:34 am

    Zolt and Guyton did some work on variable spending decisions that is able to bump up the withdrawal rate to 5-6%. the difference is that it gyrates with economics. if there is a market drawdown, you do not increase your last withdrawal amount with inflation rate. if the market is ok, you increase base on inflation.

    Many experts tell me the dividend yield strategy of not spending your principal thus protecting agasint sequence of return risk is flawed.

    • retirebyforty February 23, 2015, 10:31 am

      Can you tell me why not spending your principal is flawed? I haven’t heard this comment before.
      5-6% sounds good. During the down years, inflation is usually suppressed anyway, right?
      Thanks

      • nicoleandmaggie February 24, 2015, 6:12 am

        People have talked about this before here many times… When a dividend is paid out, the value of the company is reduced by the amount of the dividend. You’re not actually preserving principal when you take dividends, only when you reinvest them.

  • Jon February 23, 2015, 10:31 am

    Nice post Joe… I’m still young myself (28), but this is good to think about because it can help to shape my savings,and my savings goals. The dividend method would be awfully nice to attain, but we’ll have to see how things go here the next 10-20 years for me!

  • vivianne February 23, 2015, 11:01 am

    It’s a great topic to bring up. After the topic of Julie brought up, I have a lot of work to do making sure my estate will be in the right hands.

    As for early retirement, I’m going to pull the trigger when I turn 35 years old in 2 years. So I’ve been contemplating withdrawing a lot. I can technically retire from the passive income, but I’d like some cushion and backup inc case we have another 2007-2009 crash.

    Right now, I’m 50% real estate primary and investment property, 25% taxable account in equities, and 25% in retirement account (which I can’t touch or I can touch if I quit my job and get some from the 457 convert it to Roth IRA and never get taxed from it or withdraw and pay taxes on it, still deciding).

    My goal is to increase my equity by 200%, and get dividend to pay ALL of my living expenses (shoot for the average 3-4% dividend) and use cash flow from 4-plex as a cushion (keep reinvest in equity or a couple more property of opportunity comes), and not worry about 457 at all, just let it slowly convert to Roth each year to avoid taxes. The Goal is like income from dividend is one pay check for expense, the income from 4-plex is another check, this is for saving. This way I can outlive the inflation.

    Of course it’s easy to do when you make high income and still live like a college student. It might very all changed if I decide to have a kid.

    • retirebyforty February 24, 2015, 9:03 am

      That’s a detailed plan. I like that you’re planning to reinvest so inflation won’t outpace your passive income. Great job! Having a kid will probably change things a bit. You’ll probably need a bit more room and have add a little to your cost of living.

  • Tawcan February 23, 2015, 11:51 am

    I’ve read in a book before about variable withdraw and it sounds good to me. Basically you have a base withdraw rate (say 3%). Your actual withdraw rate will based on the market/portfolio performance. If your portfolio performance was good the previous year, you can withdraw a little bit more, if not you withdraw the base rate.

  • josh February 23, 2015, 1:55 pm

    Congratulations on early retirement. Can you share on what your main strategy is to focus on accumulating more? Is it blogging income, rental property, stocks? I currently work at a large company and don’t hate my job, but don’t love it either., I’d leave by job in a heartbeat if I can figure out something I can do on my own that’ll bringing in similar amount of income. The idea of significantly downsizing my lifestyle and living a very frugal lifestyle for the next 40 years so I can retire early isn’t very appealing either. I invest in stock market too, but find that my overall performance is better if I just buy index fund. However, I’ve been through the downturn, so know that I better stick to my job. If I achieve about $5 mil net worth, then I’d probably quit and retire early.

    • retirebyforty February 24, 2015, 9:05 am

      Blogging is the main way I’m adding to our retirement fund at this point. Mrs. RB40 still works so she continue to add to her 401k. We live below our means so we can continue to save. I don’t think we live all that frugally. Our expense is around $4,000 per month. Once Mrs. RB40 quit working, then we probably won’t contribute to our retirement funds anymore.

  • freebird February 23, 2015, 4:36 pm

    I’m still collecting a paycheck so I’m not withdrawing quite yet, but my plan is to turn it into a hedge fund and appoint myself manager. Then I’ll pay myself the usual two and twenty rate, meaning 2% of net investment assets plus 20% of the marked-to-market return every year. This has a slight rebalancing effect, for example a string of bad years will see less depletion than the fixed 4% rate, while with a string of good years I’ll take more off the table. Pulling it out at a constant dollar rate reverses the dollar cost averaging benefit you saw going in. True income will fluctuate, but I’m used to that.

    • retirebyforty February 24, 2015, 9:07 am

      Great plan! The two and twenty rate is a great idea. Isn’t that a bit low during the bear years? Will you have enough money to cover your cost of living at 2%? If so, that’s pretty awesome.

  • Ernie Zelinski February 23, 2015, 5:42 pm

    As a retiree who turned 65 last June, I don’t use any withdrawal rate. The reason is that this last year I had the highest income ever in my life. So my net worth went up nicely even though I did virtually no work. It appears that the same will apply this year.

    The key is to try to generate a lot of residual retirement income each year from intellectual property so that one doesn’t have to bother oneself with a “withdrawal rate.” Trust me, life is a lot easier this way. If my fortune keeps growing in retirement, the major decision that I will have to make instead of a withdrawal rate is whether to leave most of my fortune to a Brazilian go-go dancer in Copacabana (who I haven’t met yet) or to a perpetual university scholarship in my name.

    • retirebyforty February 24, 2015, 9:07 am

      The key really is to work on residual income. I need to get on that.

  • Young February 23, 2015, 7:04 pm

    Flexibility is the name of the game, when it comes to my withdrawal plan. I wouldn’t withdraw for a specific percentage of our investments. Sometimes we’ll spend around $2500~3000 a month, $4000~7000 a month during traveling times. In the beginning of our retirement, I would not touch principles of our investments. I will move some amount of 401k to a roll over IRA and then convert some amount to our Roth each year. Remaining 401k in government security will accrue daily interest just like a high interest on CD until I need more money to convert or for something else, depending on how old we are at the time. We do not have a long-term insurance nor children, therefore I got to plan accordingly. I heard this at the retirement semanar “If you have $1000 in your bank account when you die, you didn’t plan well.

    • retirebyforty February 24, 2015, 9:09 am

      I love your plan. It sounds like you have a very comfortable nest egg to draw from. You can always leave some money to the university, the library, or something that will help the future generations. 🙂

  • Jason February 23, 2015, 9:59 pm

    Joe,

    I plan to live off of dividend income only, which I’m on pace for by 40. It’s somewhat similar to the 4% SWR in that I’ll be living off of about 3.5%/yr of the portfolio. The main difference is that I won’t be selling any assets, so market fluctuations will mostly be noise over the long term. The concerns over how long one might live is exactly what scares me about selling off some predetermined amount of the portfolio, especially if one is retiring very early in life (early 40s or so).

    Best regards!

    • retirebyforty February 24, 2015, 9:11 am

      Your plan is coming along nicely. It’s also really good that you will probably still have income after you reached financial independence. It’s all gravy from there. I wonder what you’ll do with the extra money? 🙂

  • BE Pennypacker February 24, 2015, 11:01 am

    We’re not there yet, but when my wife and I do retire, the plan is to live off a combination of dividend income and rental property income. If for some reason we don’t accumulate enough savings by the time we retire to follow this plan, we’d go with the Constant Percentage Withdrawal strategy. But, instead of changing our spending every year based on economic conditions, we would maintain an emergency fund. To get through the lean years, we would withdrawal from the fund and during the boom years, we would replenish the fund.

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