EP 202: What is a Safe Withdrawal Rate from Your Savings & Investments?

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In this episode, I want to discuss a question that came up recently, and it’s a subject that while not exactly a specific divorce topic, it’s very important when you think about planning for your financial situation, and has a big impact on how you think about budgeting and finances in general. It can impact what you think about agreeing upon as part of the divorce settlement. Many of you have retirement savings, or if you’ve listened to other podcasts, you might be getting a lump sum distribution or trying to negotiate a lump sum distribution as part of your divorce settlement, and as you may know, is one of the things I advocate for particularly.

I think it makes sense many times and is underutilized, a lump sum distribution, because both parties oftentimes benefit. If you’re the person receiving that lump sum, that’s great because you have all the funds. You don’t have to rely upon your ex-spouse to make those monthly support payments, and if you’re the person making that lump sum, you also get the benefit of, well, you don’t have to make every month that support payment, and it’s all kind of done upfront, and you can also end up paying a little bit less in the form of a lump sum, because you get to get those funds out early instead of over years.

I have some great episodes on lump sum distributions, but more broadly is if you have any kind of savings, be it retirement or investment accounts or cash in a bank account, the question that I want to answer on today’s episode is, “How much can you plan to withdraw from your savings each year? How much can you plan to withdraw from your savings this year?” What am I getting at is, the question is, I like to keep things pretty simple. You have your income every year. You have your expenses, or I should say you have your income every month, you have your expenses every month. At the end of the month, hopefully your income is greater than your expenses, but oftentimes in divorce that’s not the case and particularly in the beginning.

The situation where this came up is this person hadn’t been working in 20-plus years, and they were in their 50s, and you know, you’re not going to retire for another decade if you’re in your 50s at least, and so the question was, “Well, can I just live off of my lump sum distribution that I’m trying to negotiate? How much of that can I spend each year and be okay?” Or if you just have general savings or if you’re even already in retirement or thinking about retirement or planning for retirement, you need to understand, how much of your total bucket of retirement can you spend and be okay?

I’m going to give you just a very simple rule of thumb to make things easy and some other considerations to think about when you are considering how much money you spend from your assets. The first question is, of your savings, how much can you withdraw each year from your savings? Now, the perfect answer is you aren’t withdrawing from your savings. In a perfect world, and very, very few people live in this perfect world, I’d say no one does, but in an ideal financial world, you are not withdrawing from your savings. Just to use very simple math, if you have $100,000, you’re adding to your savings every year is the ideal for most people. But unfortunately, in practice, that doesn’t work. If you start the year with $100,000, ideally you want to have $110,000 saved up by the end of the year, but you know, I understand that life happens. There’s expenses and everything else. Sometimes your income and expenses aren’t going to equal each other, and you’re going to need to borrow or you’re going to have to withdraw some money from that $100,000 in savings, and I just use $100,000 because it’s a very simple number to do math from.

How much can you spend? I give a very, very simple rule of thumb, and it’s 4%. So for every $100 you have saved, you can spend 4% of that a year and be okay. Why do I use such a low rate and such a low number? Well, if you get above 4%, then what ends up happening is it’s going to be very hard to replace that money and you’re going to be withdrawing from the principal. What do I mean? Put it a different way, is if you have $100,000 a year, I say it’s safe to plan that you can earn $4,000 a year in dividends, interests, and appreciation over the long term, if you are just planning for that.

Now, hopefully your rate of return on that $100 is higher than 4%, but I wouldn’t plan on it. You never know. I know the market’s gone up quite a bit for the last decade as I record this, but there’s always downturns. Interest rates fluctuate, the economy fluctuates, the market fluctuates, and if you spend more than … If you plan on earning 8% or 10% or 15%, then that’s probably not realistic, and that’s a terrible plan from a financial perspective if you’re making your budget and budgeting, because if you fall under those projected returns, then you’re not going to have enough savings for later in life. The plan is, is, look, you can stay about even with your savings if you only spend about 4% a year.

Now, 4% a year is not a lot, and if you have $100,000 in savings, some people I know don’t have anywhere near that amount. I know some people listening have many multiples of that amount, but if you have $100,000 a year in savings, then you can only plan to supplement your budget for $4,000 a year and expect to be okay. You know, if you spent $3,000 then that’s even better, or zero, that’s great, or even $1,000, but once you get over to $5,000 or $6,000 or $8,000 or $10,000 a year from your savings, it’s going to be very, very hard to replace those funds. And so for all of you thinking about your budget and what you can spend and what can you live on, think about 4% a year. If you have $1 million, that would be $40,000 a year that you can live on and withdraw from your assets, or $100,000, I said it’s $4,000, and it fluctuates to whatever number is relevant to you.

Now, second point I want to bring up connected to all of this is that sometimes when you have to, it’s okay to spend a little bit from your savings for the first couple of years after divorce. I don’t advocate necessarily for spending additional funds, but there’s always practical realities and oftentimes it’s easy to forget the reality of one’s situation. If you haven’t gotten a job or if you don’t have a high paying career, or you haven’t worked in a while and you’re trying to reenter the workforce, for many people it’s unlikely that you’re going to be earning six figures as that first job, particularly over that first year, even when you’re well educated. And sometimes maybe you are actually, and if you are, then more power to you. That’s awesome, and make sure you have the other elements of your financial picture set up.

But if you’re thinking about kind of reentering the workforce, which is a common scenario I deal with, or if your spouse is thinking about it and you’re trying to present a persuasive case to your spouse, you have to kind of keep that in mind as well, is that maybe it might take them a year or two or three to retrain and get back on your footing. And so if you have that $100,000 pot, well, maybe you do need to spend $5,000 or $7,000 or $12,000 for a year. Yeah, that’s a big bite and it does cut a lot into your savings, but if it’s only for a year or two at the most, then you can use that and treat it like an investment to get yourself back on track, but treat it really like an investment, an investment in education, an investment in job training, an investment in some sort of resource or another asset that gives earning potential.

If you’re spending that $5,000 or if you’re spending $10,000 in a year just to keep up with your mortgage that’s in a house that’s too big, or if you’re spending that extra money on a car payment that’s too high, then I wouldn’t really think that’s a great use of funds because you’ll never get that money back. But oftentimes you’re retraining or going … I have tons of clients who go back to school and become any number of jobs or need to kind of dust off the old degree. They might start at entry level, but since they have some life experience, they get to move up quickly, and it only takes them a year or two or three at the max to get really back in the flow of things in a pretty decent way. I mean, oftentimes won’t necessarily be the CEO of a big company, but still earn a very good living for you and your family, and in those scenarios it’s okay if you need to spend a little in the short term with the understanding that as you plan your budget and plan what you’re thinking about, that that’s a temporary thing and you should be working on or try to work on any other lifestyle adjustments you can to see how things are going on.

Also, you should be planning to not spend more than that 4% over the long term, but at the same time money is there for when you need it. It’s just, try and save it for things you really need, not something frivolous like a vacation when you can avoid it, particularly right after or during or while planning for a divorce situation, because you don’t know all the moving parts and the hidden expenses and just all of the things that happen during this process.

Then the third thing I just want to bring up is that when you spend more than 4%, you can start eating away at your principal. What does that mean? Well, what happens is you end up in a negative downward spiral. If year one, and I’m going to just oversimplify this a little bit, I’m going to use the number $100. Let’s say you start with $100 in savings. You spend $4 of it, so you’re at $96, but maybe you get some investment returns, so that gets you back to $100. So you kind of stay around even over the course of the year. Well, what if the next year you spend 7% but you only get 4% in investment returns? And if someone who’s really good at math understands what I just said, you’ll say that what I said is not exactly accurate, but let’s just say you start at $100. Year two, you’re still at $100, and you spend 7%, so you spend $7 and you only earned $4. Well, then you’re down to $97. Well, to get back up to $100 is more than 4%. you have to get up to 5% or 6% to get back to that $100.

Now, if you spend more again the next year, let’s just say you’re down to $92. Well, getting from $92 to $100 takes a lot more effort and a lot more time. And if you spend, again, and let’s just say you get down to $80, well, getting from $80 back to that $100 is a big amount, and without getting to the exact numbers and exact percentages, trying to stay even gets harder and harder and harder every year, and not only does it get harder every year, if you spend 4% of $80, that’s only $3.2. So 4% of $80 is $3.2, where 4% of $100 is $4, so you have two things that are happening at the same time. One is that when you’re spending your principal, you just have less overall money, and the second thing is, is an equivalent percentage of spending on a lower total amount of money is sort of a downward spiral, because you get, for every dollar you lose, you can withdraw less the next year, and then the next year and the next year, and you keep running out of money even if your percentage of withdrawal kind of stays the same, if you’re above that 4% number.

Hopefully I illustrated that clearly for you. It’s kind of a lot of numbers and moving parts, but the point is this, is that if you’re withdrawing from your savings every year, it gets harder and harder and harder to catch up, and we don’t want that happening to you. Does that make sense? I hope that makes sense.

The three points are, first point is, 4% rate for your savings. If you’re planning about planning on budgeting, assume you can only spend 4% a year on your savings, or out of your lump sum, out of your savings money. And hopefully less than that. The second thing is, if you have to, it’s okay in the short term to spend a little bit of money the first year or two after the divorce because practical realities necessitate that happening. But make sure it’s only a short term thing and not something over the long term. Then the third point is that if you’re spending more than 4%, you start eating away at your principal, which leads to a negative downward spiral, and you want to avoid that. So plan wisely as you think about your settlement and your divorce settlements, and it’s a very important long term planning tool to keep in mind both while you’re working and even while you’re thinking about retirement.

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