The 4% Rule

Over the last century a balanced portfolio of stocks and bonds has averaged about 7% annual growth.

The current tax rate on capital gains is 15%, and inflation has historically hovered around 2%. Let's be pessimistic and suppose that of that 7% growth, 3% of it goes toward paying taxes and managing inflation.

That leaves 4% of the balance in post-tax, inflation-adjusted annual average income. You may see this concept referenced elsewhere as a safe withdrawal rate.

This is a really useful fact! It allows us to translate between income and assets:

  • If you've invested a million dollars, the 4% rule tells you that you can withdraw $40,000 of post-tax inflation-adjusted income from it every year in perpetuity.
  • Conversely, a regular income stream of $50,000 will require about $1.25MM in invested assets.

This is just a general rule of thumb: the 4% rule doesn't literally hold in every possible case, and different allocations and historical situations can, of course, affect it. It's fundamentally hard to draw a perfectly stable income from a volatile asset, which stocks certainly are.

Read up on the Trinity study for details on how the 4% rule came about and where it may not apply.

Early Retirement

The 4% rule has an interesting corollary: once you've invested 25 times your annual expenses, you can live off those investments indefinitely.

If you can live on $30,000 per year, for example, you'll only need $750,000 invested to provide enough income to retire. That's not a small amount of money, but between an engineer's salary, a high savings rate, and the magic of compound interest, it's thoroughly possible.

If you find this intriguing, you'll be delighted to learn that there's a fascinating community of people out there exploring the possibilities of “financial independence.” See, for example:

There are many caveats and addenda to consider: what if the market crashes right after you retire? How can you get early access to money in retirement accounts? How will your expenses change without a job?

These questions fall outside the scope of this book, but rest assured that much digital ink has been spilt over them. Follow the above references if you'd like to venture down this thoroughly interesting rabbit hole.

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