Explain the Rule of 400
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When you think about retirement, what comes to mind? Do you think about retiring on a beach in Mexico drinking as many margaritas as you want or is it just having the ability to hand in your notice to your boss and quit your nine to five job forever? Whatever retirement looks like for you what's more important is how to actually get there.
In this article, I'm going to explain to you how you can use the rule of 400 to reach retirement a lot faster and more reliably than you would have ever imagined. You see, there are a lot of different rules when it comes to the world of finance. There’s the rule where you're supposed to put 20% down when buying a home or you should save 20% of your income when using the 50/30/20 budget. Well, the rule of 400 the same way in that it is a financial guideline that you should follow if you want to retire early.
At its core, the rule of 400 explains how much money, after tax, you need to accumulate in order to be able to afford to retire, however the first aspect to keep in mind is that you are not using the monthly figure that you are spending right now to perform this calculation but instead are using the amount after tax that you intend on spending during your retirement years. Now one would maybe think that this would be the same dollar figure especially if you don't intend on changing your lifestyle down the road however you have to realize that certain aspects of your life will change when you get a little bit older and even if you do retire early you will probably have less monthly expenses than you do now. For instance, when you retire you'll probably not have a mortgage which means that you will need to spend less money on your housing costs every single month. This reduction in cost will allow you to require less money on a monthly basis in your later years meaning your retirement savings target will naturally be less.
Beyond the cost of housing, other cost factors that may or may not be relevant in the future include the cost of supporting your kids or changes in your anticipated retirement standard of living. For instance if you intend on traveling a lot in your retirement years then you should anticipate needing a larger amount of monthly income after tax income. Alternatively if you're going to live a very modest lifestyle in retirement then you will need less money to retire on which means that ultimately you should be able to reach this target in a much sooner timeframe. Let's now use an example of how this calculation is performed so you can see firsthand how much money it would actually cost you to retire.
Let's say you intend on spending $5,000 a month after taxes in retirement. If this is the case, then the math is quite simple. All you have to do is multiply the $5,000 after tax amount by 400 to get the total amount that you need to save for retirement. Before you set this figure in stone, there are a couple considerations I want you to keep in mind. Firstly, envisioning your future needs can be difficult therefore I always recommend adding an extra 20% to the amount of money you will need after tax when doing this calculation so that you do not undercut how much money you will need in the future. One way to do this is to add 20% to the monthly amount that you anticipate yourself needing in retirement. Another way to add in this financial cushion is to use a factor greater than 400. For example for those people who are more cautious I often recommend they use a factor of 450 which will allow them to be able to save up more money prior to retiring so that they will have less financial stress associated with whether or not the funds will last them through their retirement years.
At this point, you may be wondering what the origins are of the rule of 400. The rule of 400 works very similarly to the classic 4% retirement rule. Ultimately, it is a blanket calculation used to estimate future required funds that will allow you an appropriate amount of withdrawals in your retirement years on which you can rely upon. In the example of the four percent retirement rule, the standard calculation is your annual expenses multiplied by 25 which will give you the total amount that you'll need to save for retirement.
The rule of 400 is a slight off-shoot from the 4% rule calculation and it works on an after tax basis and monthly basis. Beyond these minor nuances, there is a much larger factor that is actually very relevant when performing this calculation and involves the tax implicated with your retirement nest egg. You see, the 4% rule does not factor in the fact that the amount of money you save in your retirement nest egg is likely to have to be taxed upon withdrawal.
Many of your retirement savings vehicles will hold your funds in an account that has yet to be taxed. For instance, if you were investing in a 401K through your employer or in an RRSP in a Canadian context, these funds are deducted for tax purposes in the year that you contribute them and as a result will have to have tax applied to them when you withdraw them in your retirement years. As such, if you need a certain amount of after tax income to support your lifestyle, you will actually have to withdraw more than that amount in untaxed income meaning that your retirement savings target may actually have to be higher than you initially anticipated.
Let's use an example to illustrate how the tax implications factor into this calculation. Say that you intend on spending $5,000 a month after tax in your retirement years. Mathematically speaking if you were to multiply this $5000 by say a factor of 300, you would get $1.5 million dollars as your retirement savings target. Withdrawing 4% annually from this fund would provide $60,000 which is $5,000 per month times 12 or your annual living expense requirement. However this calculation does not take into consideration the fact that you have to pay tax on these drawings and as such will not actually offer you the $5,000 in cash you need to cover your expenses. Assuming you were going to pay a tax of 25% on your with drawings in your retirement years you would as such require applying a much greater factor when performing your retirement estimate hence the rule of 400.
Now let's use the same example where we apply a factor of 400 instead. If we take the $5,000 after tax monthly expense requirement and multiply it by 400 you will get a total retirement target of $2,000,000. If you were withdrawing at a 4% rate every single year this will grant you $80,000 from which we have identified that 25% will be consumed by tax. After 25% is deducted from your $80,000 you are then left with $60,000 which equates to the $5,000 you need every single month to live your desired retirement lifestyle.
While it's true that not all of your retirement funds maybe sitting in a pre tax state I believe it is better to be conservative with this estimate than to be too aggressive and given that you probably have funds in both pre and post tax states in your retirement accounts it is better to apply a higher factor in this calculation than a lesser one.
One final mathematical consideration to take into account is how much money you already have in your retirement account. If you have never contributed towards your retirement then you will want to do this calculation as I previously described however you have to do one extra step if you've already started to save for your golden years. Once you have your retirement target figure, which you calculated as your monthly after tax needs multiplied by 400, what you will want to do is subtract how much retirement savings you already possess. This calculation will give you the total amount that you still need to accumulate in order to retire. For example if you have calculated that you need $2,000,000 in retirement savings to retire and you've already accumulated $50,000 in your 401K then you only need $1.95 million dollars in order to hit that long term financial target that will get you to the promised land.
Investing 101
As I previously mentioned, if you want to rely upon your retirement fund for financial sustenance in the future you will need your retirement account to be earning at a greater rate than you withdrawing from it. So now I think it's worth mentioning a couple options you can consider when you start to invest towards your retirement years. For those who want a very easy approach to retirement investing look no further than index funds. From their inception until 2019, index funds tracking the market as a whole have yielded an average return of 10%. Of course, some years like during the 2008 recession these funds would have experienced returns less than this average amount however chances are you aren't going to be pulling your money out during one of the worst recessions in modern time. Therefore, as long as you rely upon the average return you will be sure to have your portfolio grow at a greater rate then at which you are withdrawing from it.
Alternatively if you want to be more hands-on in your investing process then you can look at buying individuals stocks, one of which could be AT&T. While the stock does not always appreciate by more than 4% annually, what it does offer is a very reliable and lucrative annual dividend. In recent history, AT&T has been yielding a 7% dividend return to its investors. With a 7% dividend return, this stock can help supplement your retirement fund with enough money to cover the amount that you'll be withdrawing on an annual basis. Of course, I would never recommend you put all of your retirement contributions towards this one stock but it does act as a great example of how you can achieve reliable returns that can keep you afloat in your retirement years.
Getting Started
When it comes to retirement savings, I often hear people say, “I just don't have any money to invest otherwise I would”. Luckily you don't need a ton of money to start saving towards retirement and I recommend you set a target of investing $100 a month on a consistent basis towards your golden years. What I want to do now is go over a couple of ways that you can unlock that $100 if you truly don't think that you have the extra money it takes to build your future wealth.
The first recommendation I have is to start budgeting. Chances are there's an extra $100 that you are spending every single month that you can divert towards those enjoyable years of sipping margaritas on the beach in Mexico. Perform a review of your monthly income and your current expenditures. Within your expenses, ask yourself if there are any areas that you can reduce and chances are there will be a few. If after reviewing your expenses you truly think that there is nowhere to cut from then we need to attack this problem from the other side of the income statement. In short, you need to make more money.
What I recommend in this situation is for you to either pick up a side job where you will work a handful of extra hours every week or begin freelancing with a couple of clients which will give you the extra income you need to support this investing endeavour. Now I know the thought of working extra hours in the week may seem unbearable however if you never set yourself up for retirement, the sad reality is that you will be working until you die.
Now I will be the first to admit that investing $100 a month isn't going to make you rich overnight. In fact, if you were to invest $100 a month for 30 years at a 7% return it would yield you just over $120,000 and let's face it you cannot retire on that little amount of money. However what investing $100 a month allows you to do is build a habit of investing.
You see many habits require you to overcome a certain amount of activation energy in order to begin them. For instance, one thing that keeps people from going to the gym is the activation energy it takes to get in their car, drive to the gym, get changed and then finally start working out. However if instead you decide to workout at home you have lowered the activation energy it takes to get started as you had have cut out the drive and have made it easier for you to start exercising. It’s in the same way that investing $100 a month gets you into the groove of consistent investment. Then as your income begins to rise over time, you can then start to contribute more on a monthly basis into your retirement account. For instance, if you were to invest $1,000 a month at the same 7% rate of return for 30 years you end up with over $1.2 million dollars which would leave you a lot closer to achieving a retirement fund that could support you in your old age.
Finally, before you dive into your investing journey there is one other question you must ask yourself and that question is does it make more sense to pay off any outstanding debts I have than to contribute towards my retirement account. As indicated in this article, it is very important to invest for your retirement years however carrying debt can be very detrimental in you achieving these longer term milestones. For instance if you were carrying high interest debt like credit card debt then the interest you are paying on a monthly basis when netted against your returns on your investments will actually have you going backwards financially. You see, paying interest on high interest debt is equivalent to the interest that you earn when investing and if you have high interest debt like credit card debt that is charging you 19% annually then you are much better off to pay this down first then to use that extra $100 a month you have to invest in say an index fund that yields you 9 or 10%. However if you do have outstanding debts but their associated interest rates are not as high as the amounts you anticipate you can get from investing then I actually do recommend that you start investing for your retirement years with your disposable income.
Now as I previously mentioned this strategy only works if you are consistent and as humans we are imperfect creatures. In an investing context, this means that it can be easy to falter on consistently making contributions towards your golden years. As a result, if you want to be successful and have a nice nest egg awaiting you later in life you must set up a system that you can rely upon to succeed financially. What I recommend is that you set up an automatic contribution from your bank account towards your brokerage account. Alternatively, if you are investing through your employer, have your employer deduct a portion of each paycheck where this deduction is contributed to your retirement fund. Doing this offers two benefits. First, automating your investing process will remove the task of investing from your plate allowing you to focus on other important activities in your life. Moreover it will ensure that you are not tempted to spend the money that you have available at the end of the month on consumable goods rather than investing it into your retirement account. In short there is really no reason why you should not set up automated contributions towards your retirement.
Beyond the benefit of reducing your stress of your future financial situation investing into your retirement on a monthly basis also offers you some benefits in the short term. Sadly many people overlook these benefits and only see their current contributions towards their retirement as stealing some happiness from their current state and deferring it into the future. Luckily, this isn't entirely true. When you are investing towards your retirement through a tax deferral vehicle such as a 401K or an RRSP, you actually reap tax benefits during these contribution years. You see when you contribute towards these accounts the amount that you contribute reduces your taxable income for the year and as such reduces how much tax you need to pay on an annual basis. This is why you must factor in tax remittances that will be paid when you withdraw from your retirement account because during the building phase of your retirement journey you’re going to be avoiding paying this tax. While paying less tax may not be as sexy as spending your disposable income on material goods, I think we can all agree that having a smaller tax bill at the end of the year is a nice compromise while also building your fortune one monthly contribution at a time.
Therefore if you want to ensure you have enough money in the bank when the time comes to retire then I strongly recommend that you perform your own rule of 400 calculation and start investing if you aren't already towards quite frankly the most important financial milestone of your life.