Retirement Withdrawal Rate, Explained

Ideally, the money in your retirement funds is supposed to stay in there for the long haul, building tax-advantaged interest so you have a nice nest egg for your twilight years. Sometimes, though, you just need money, and tapping your retirement fund to make an early withdrawal can give you access to cash without going into debt. Whether that’s a good option depends not just on your situation, but on the type of retirement account you have, as different accounts are subject to different rules, risks and fees. To learn more about early withdrawals so you can decide whether or not taking one to pay off debt would be right for you, keep reading.

If you’re not familiar with the different kinds of retirement funds, you may want to read our post on where to put your savings before you continue, as knowing the basics will help you understand the details of early withdrawal more easily.

Early withdrawal from a 401(k)

The traditional 401(k) is the workhorse of retirement savings in the U.S., letting people stock away up to $18,500 per year and reducing their taxable income by whatever they saved. Cash out your 401(k) early, though, and that tax deduction can come back and take a big bite out of your wallet. Any withdrawals you make from your 401(k) are considered income that you have to pay federal and state taxes on, and if you take that money before you’re 59 1/2 years old, you have to pay an additional 10% early withdrawal tax penalty. For example, let’s say you make $40,000 per year, and you take an early withdrawal of $10,000 out of your 401(k). That puts your taxable income for the year at $50,000, so between the 25% federal tax rate, a typical state tax rate of 5% and the 10% early withdrawal penalty, you will pay $4,000 in taxes and only get to use $6,000 of the $10,000 you withdrew. That number also doesn’t factor in the money you’re losing because that $10,000 is no longer earning interest in your retirement account, so your total losses are actually even higher.

While you can’t really avoid paying taxes on 401(k) withdrawals, you can potentially avoid the 10% early withdrawal penalty if you meet one or more exceptions that the IRS has laid out. To name just a few examples, if you become permanently disabled, you use the money to pay medical bills that cost over 10% of your adjusted gross income or you’re a qualified military reservist called to active duty, you’re exempted from the early withdrawal penalty. You can also avoid the early withdrawal penalty by taking out a loan on your 401(k) balance instead of withdrawing it, although 401(k) loans are subject to legal limits. Your loan has a maximum equal to $10,000 or 50% of your account balance (up to $50,000), whichever is greater, and it has to be paid back within 5 years with at least one installment paid per quarter. On the upside, 401(k) loans don’t require a credit check, and often have interest rates only one or two percent above the prime rate, so they can be a way for people with poor credit histories to get access to low-interest loans. However, you are effectively borrowing against your own future. A personal loan may have a higher interest rate and stricter repayment terms, but failing to pay a personal loan can’t wipe out your retirement accounts, even if you have to file for bankruptcy.

Early withdrawal from an IRA

Withdrawing early from an IRA account functions in mostly the same way as withdrawing from a 401(k). However, they have a few more exceptions available for avoiding the early withdrawal penalty than 401(k) plans do. You can withdraw money early from an IRA account without penalty if you use the money to pay health insurance premiums while you’re unemployed, you’re a first-time homebuyer using the money to pay for your first home (up to $10,000) or you use the money to cover qualified higher education expenses for yourself, your spouse, your child or your grandchild. Additionally, if you take money out of your IRA early and then realize you don’t need it, you can roll the money back into your IRA within 60 days to avoid taxes and penalties. In return for those advantages, IRAs don’t have access to a couple of the exceptions that 401(k) accounts have related to employment, and you can’t take out loans on your IRA like you can with a 401(k).

Early withdrawal from a Roth account

Both Roth IRAs and Roth 401(k)s are probably the best retirement accounts from which to make early withdrawals, as they have a special rule that lets you avoid the early withdrawal penalty in addition to the normal IRS exceptions. First, since the money you contribute to Roth accounts gets taxed when you deposit it, you can withdraw the money you’ve contributed with no taxes or fees. Once you’ve withdrawn all of your contribution money and start withdrawing the money your Roth account has earned as interest, that money isn’t subject to taxes or penalties as long as it meets something called the “five-year rule.” The five year rule states that, once five years have passed since the tax year of your first Roth contribution, you can withdraw the earnings from your Roth accounts tax-free. The confusing thing is, the five-year rule works differently depending on if you have a Roth IRA account, a Roth 401(k) account or traditional IRA account that you then converted into a Roth IRA. For Roth 401(k) and converted Roth IRA accounts, the five years begins the year you made your first contribution to that particular account. For normal Roth IRA accounts, the five years begins the year you made your first contribution to any Roth IRA account, regardless if it’s the one you’re currently withdrawing money from.

Withdrawing money from your retirement accounts early isn’t something you should do lightly, as it can set your retirement goals back years. However, if you’re in a situation where you’re desperate for money, it can be a reliable last resort. Before you commit to an early withdrawal, be sure you explore all of your other options, such as 0% intro APR credit cards. For more financial advice, follow our personal finance blog.

Planning ahead for retirement is a difficult challenge for everyone. It’s often unclear how much we should be saving, and weighing the benefit between money in hand now and money in retirement later is a tough choice for many of us. When you start asking questions about how to invest and where to invest, it gets challenging very fast.

The Simple Dollar offers a robust guide for retirement planning as a whole, but today we’re focusing on one very important element of retirement planning: withdrawal rate.

Withdrawal rate is simply the rate at which you take money out of the account, usually expressed as a percentage of the initial balance. Let’s say, for example, that you have $500,000 in your 401(k) and you choose to withdraw $20,000 a year in retirement. You have a withdrawal rate of 4% or $20,000 divided by $500,000. 

Let’s look at some obvious things.

If your investment is just sitting there and not earning money on its own, a 4% withdrawal rate will empty your account in 25 years. If you take out $20,000 a year from that $500,000 account, it will be empty 25 years from now. Similarly, if you take out $50,000 a year — a 10% withdrawal rate — that $500,000 account will be empty 10 years from now. 

However, your money isn’t going to sit there idly within that account. It’s going to be invested in some fashion, earning a return while you live your life.

For example, if you have a 4% withdrawal rate and you magically have some investment that earns a guaranteed 4% return each year, then you’ll basically never run out of money. If you have $500,000 in your account, you withdraw $20,000 a year, and the other $480,000 earns a 4% annual return, your account will earn $19,200 in that year while you sit there, leaving your balance at the end of the year at $499,200. It will take many, many, many years to empty out that account, far more than your lifetime.

The trick, of course, is that there is no investment that earns money like clockwork like that, aside from a few very low-interest options. You might be able to lock in a 2% return, or you might be able to buy an annuity of some kind (with a lot of fees attached), but there’s basically no way to absolutely guarantee yourself that high of a return.

This leaves you with some choices. One option is to keep saving until you have enough in retirement that you can basically lock in a very low withdrawal rate.  If you have $2 million in retirement, for example, you can withdraw $20,000 a year and that would be at a 1% withdrawal rate.  It’s easy to find investments that have a guaranteed 1% return. The problem here, of course, is the initial amount you need to save is enormous.

Another option is to simply trust that your money can be invested well enough to return 3% or 4% per year very reliably, at least for long enough that you can live out your natural life at that withdrawal rate. 

There’s been a lot of research into that very question, and the general conclusion across many studies — particularly the often-cited Trinity study — is that you can easily build an investment portfolio that will ensure a safe 3% withdrawal rate forever and a safe 4% withdrawal rate for a very long time (likely far longer than your natural life) with extremely high likelihood. This includes adjusting the annual amount for inflation.

In other words, if you have that $500,000 amount properly invested, you can pretty safely withdraw $20,000 the first year, then the same amount in later years adjusted upward with inflation. Paired with Social Security benefits, this offers a solid retirement income for many people.

How is this impacted by retiring early?

If you’re considering early retirement, you must consider that the first handful of years of your retirement will not be supported by Social Security, which won’t start benefiting people until they’re in their mid-60s. Thus, at first, you’ll need to live entirely off of your savings.

The safest way to do this is to simply do the entire calculation based on your expected annual spending in retirement at a 4% withdrawal rate. That way, when Social Security kicks in, you can either treat that as a boost to your income or an opportunity to cut down your withdrawal rate. 

So, if you’re planning on spending $50,000 a year in retirement, and you’ll be withdrawing that at a 4% rate, you’ll need to have $1.25 million saved.

Are other withdrawal rates worth considering?

It can be tempting for some to consider a higher withdrawal rate than 4%, as that enables a smaller target number to save for. If you only need $20,000 a year and want to use a 5% withdrawal rate, after all, you only need to save $400,000 in total.

The problem with a higher withdrawal rate is that you run the risk of running out of money very late in your life.  In that above example, the money runs out in 20 years without any investment returns, and somewhere around 25 years with conservative investment. It may last the remainder of your natural life, but it also may not last, leaving you in a difficult position. The higher your withdrawal rate, the higher the chance of running out and leaving you in a tough spot in your final years.

On the other hand, having a low withdrawal rate — particularly below 3% — means that your money is almost certain to continue to grow over the long run, even with your withdrawals. This is a good approach to use if you intend to leave a nest egg for your children or partner or to pay for high-quality end-of-life care for yourself.

What if retirement doesn’t go as planned?

Retirement can offer a lot of unexpected challenges. Things like premature death of a spouse, rising health care costs and higher-than-expected inflation can all throw a monkey wrench into any retirement plan.

In terms of withdrawal rate, the best strategy that you can follow to avoid these kinds of unexpected retirement challenges is to simply use a lower withdrawal rate, particularly at the start of your retirement, so that if unexpected events occur, you will have the ability to bump up that withdrawal rate later or even withdraw an extra piece of your retirement savings.

As noted above, a 4% withdrawal rate from your retirement account is likely to last for at least 30 years, but a 3% withdrawal rate will last for far longer. The lower withdrawal rate leaves more money in retirement accounts, and that also means more investment returns, which means even more money available to you in an unexpected event.

The answer is simply to save more for retirement and then, when it comes time to retire, select the lowest withdrawal rate you can, which will ensure that you have money in reserve for whatever may come. 

How can I take advantage of this information?

The single most powerful thing that anyone can do for their retirement savings is to start saving early and save as much as possible. The higher your percentage contribution on your 401(k) or 403(b), the better. The larger your Roth IRA contributions, the better.

The reason is the “snowball effect” of retirement savings.  Retirement savings are a lot like a snowball rolling down a hill.  The longer that snowball has to roll, the bigger it will be, which is why you want to save earlier, to give your “snowball” time to grow.  Similarly, your snowball is going to grow a lot faster if you roll it in an area with a lot of snow rather than an area with little snow, which is why you want to contribute as much as you can, all the way along.  As time goes by, your retirement savings will start to build on itself, and the more time you give it (and the more contributions you give it all the way along), the faster that automatic growth will be.

When you reach the bottom of that hill, you want a big fat retirement snowball, so that you can retire with a safe withdrawal rate that will support you in the life that you want to live.

Save early, save big.  Good luck!

Trent Hamm
Trent Hamm
Founder of The Simple Dollar

Trent Hamm founded The Simple Dollar in 2006 after developing innovative financial strategies to get out of debt. Since then, he’s written three books (published by Simon & Schuster and Financial Times Press), contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.

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