The 4% Plan vs. 3% Plan vs. 3.5% Plan

A number of prior posts have mentioned the 4% Plan. That’s one of a few schemes for rationally spending down your assets once you have retired and switched from saving to consuming. But whether 4% is the “right” number will depend on many factors. One of them is the type of savings buckets in which your assets dwell.

First, what is the 4% Plan? Under the 4% Plan, you add up your investment assets on the day after your retirement party, multiply by 4%, and that’s your budget for the year. Then every year you increase the dollar amount by the prior year’s inflation, and you've got yourself a new budget. I’m not crazy about the 4% Plan, but at least it’s a plan, and it's simple enough.

Of course, nothing’s simple. Because taxes matter, and one of the important variables we have glossed over is this: In which of the three main types of savings buckets do your assets sit? Are they in a pre-tax retirement account like a traditional Individual Retirement Account? Or a newfangled Roth account? Or a taxable investment account? (Chances are they are in some combination of the three, but for the sake of discussion, let’s pretend they are all in one or another.)

Here’s why the answer matters. The number 4% was arrived at by financial professionals to result in a distribution amount that is as big as possible, while still maintaining a high likelihood that you will not run out of assets during your lifetime (or the joint lifetimes of you and your spouse). The professionals who arrived at that figure assumed your assets were invested in a traditional tax-favored retirement account, like a 401(k) account or IRA.

So let’s follow that through. Let’s say on your retirement day you have $1,000,000 saved in a traditional IRA. You figure 4% is $40,000, so that (plus future inflation) is your budget. But what about taxes? You haven’t paid taxes yet! If, for example, your overall marginal income rate is 25%, then $10,000 goes to pay your taxes, and you are left to live on $30,000. You can’t eat taxes. 4%, it turns out, is the rate at which you can deplete the account; not necessarily what you get to spend. That looks more like 3%.

Now let’s change the facts. Say you have the same $1,000,000, but it’s not in a traditional IRA; instead it’s in a Roth IRA. Your sustainable distribution is the same 4%, or $40,000, but now all income taxes have already been paid, so you get to spend the whole $40,000 on yourself. With a Roth savings bucket, 4% is truly 4%.

One more scenario. Assume the $1,000,000 is in a taxable investment account. You’ve already paid income taxes on that $1,000,000 so you get to spend your entire distribution on yourself. But it should be a bit less than 4% in this case. I’m not sure how much less, but I think probably around 3.5%, or $35,000 in the example. Why do you have to shave the 4% down? Because the professionals who came up with the 4% number assumed you were investing your $1,000,000 in some sort of tax-exempt environment, like an IRA, in which you would not have to pay income tax on your investment earnings (although you would have to pay income tax on your distributions, as we saw two paragraphs above). So if your investment returns (not your distributions) have to be shaved by income taxes, it stands to reason that your long run sustainable distribution percentage will have to be shaved as well. Perhaps down to 3.5%. For a description of the factors that go into this particular haircut, see February 3’s post.

As I said, in reality your retirement savings will likely be housed in all three types of savings buckets, so your own spending percentage will be some blend of the three numbers.

Oh, by the way, your own percentage will also vary depending upon your asset allocation plan. But that discussion is for another day.