Are you wanting to break free from the 9-5 grind and achieve financial independence but have a lingering question of, how much is enough?! Well, you’re in the right place because that’s what this post will address specifically. Having clarity on your financial independence number through the 4% rule will become your North Star and empower you to turn a dream into the first stage of a plan. So lets get into it…
NOTICE: The content of this article is not to be considered as a legal opinion, financial advice or tax advice. Millionaire Wealth Guide does not hold itself out as a legal, financial or tax advisor. If you want to receive a legal opinion or tax advice on the matter in this article please contact us directly and we will refer you to a legal practitioner.
What is the 4% rule?
A foundation of the financial independence retire early movement is the 4% rule which is a simple and powerful concept to guide you towards your financial freedom goals. Here’s an overview of how it works:
1. Annual Expenses – you first need to determine your annual expenses which is effectively the total of your core expenses including housing, utilities, food, and travel and entertainment costs.
2. Multiply your Annual Expenses by 25 – having calculated your annual expenses its time to multiply the total by 25 which becomes your North Star target!
3. 4% Withdrawal rate – the 4% rule is a guiding number in the investment world for how much you can withdraw from your total savings without fearing you will run out of funds. Of course, this is for guidance and like anything in life is not guaranteed.
By way of example, if you calculate your annual expenses are $45K, $45K x 25 = FI number of $1.125M. Taking this a step further if you withdraw 4%, this will be $45K i.e. the same as your annual expenses!
Why the 4% rule is an excellent guide
The fundamental logic behind the 4% rule is that your investments should grow, on average, by the same amount as the amount you withdraw each year. The 4% rule is also based on research in the Trinity Study, where Professors of Finance tested a variety of withdrawal scenarios for different combinations of stocks and bonds using market data between 1925 and 1995. The conclusion of the study was that withdrawal rates between 3% and 4% were not expected to deplete an individual’s portfolio over a 30-year period. This AAII article, supports the sustainability of this approach if you are interested in the full details!
Is 6% the new 4% withdrawal rate?
It’s important to note that Trinity study showed a 95-98% success rate of withdrawal over a 30-year period and this dropped to 93% over 40 years and even lower as the time horizon increased. It is therefore important to consider the fact the 4% withdrawal rate may not be considered safe if you intend to retire significantly earlier. While there is no universal perecect number , there is new insight that 6% may well be the new 4% for those wishing to achieve financial independence at an early age. Consequently, there is some new insight that a withdrawal rate of 3.5% is a more conservative and better guide for safely withdrawing over long periods of time. Let’s see this as an example using the same annual expenses as in the 4% example so we can see the contrast:
25 x $45k = financial independence number of $1.125M
30 x $45k = financial independence number of $1.35M
So, the difference is $225K to account for that more conservative approach. Assuming your target was the higher $1.35M you would be withdrawing at a lower 3.33%. This withdrawal rate has been proven to be effective for withdrawals over a 50 year period as opposed to a more traditional 30 year period.
Summary and next steps
Congratulations, you’ve now calculated your financial independence number and got your North Star! Hopefully you’re now feeling empowered to take the next step in your financial independence journey on your path to abundance and freedom. If you would like to learn more about how to achieve financial independence check out our detailed guide here!
About the Author
