The Rule Of 25 Times and The 4% Rule
Have you ever wondered how much you need to retire? The truth is, thinking about retirement is intimidating. It doesn’t matter if you’re 25 or 55. Figuring out how much you need to invest is scary. The biggest issue I think most individuals face is just getting started.
If you’ve ever met with a financial advisor, they tell you that you need millions of dollars before you can retire. So how accurate is that?
Well, that is impossible to say without knowing your retirement desires. What you dream of for retirement will have a tremendous impact on the amount of money that you would need at retirement. If you want that second home, those brand new cars every two years and so forth, that money needs to come from somewhere and be planned for.
Are you going to be the person traveling from country to country and going on 10 trips a year? Do you want to upgrade to a mansion? Maybe you plan to sell everything and live out of an RV. Maybe you just want to maintain your current, modest lifestyle without having to worry about money.
The fact is, there are so many variables that it is hard to determine. My goal today is to give you two quick strategies to quickly figure it out. They come by different names, but they are identical in nature.
Are you ready to jump to it?
The Rule Of 25 Times
So, to get started, I want to discuss the Rule of 25 times. There is a great community out there that has been leading the way to financial independence. The beauty is that it doesn’t matter how old you are. It just matters that you are getting started.
If you haven’t heard of the community, it is called FIRE or Financial Independence Retire Early. I am going to suppose you haven’t heard of the ChooseFI (Choose Financial Independence) community. In that case, I highly recommend going over there and begin reading through their articles and listening to the podcast. They have a fair bit of information that I hope to touch on to give you extra guidance as you take this journey through life.
So often, we stress out because we don’t know where to start. If you want to retire at 30, how much do you need? What about 50?
Well, with this simple equation, you can literally write down the math on a napkin and figure it out. Heck, it could be a cool party trick for you and your friends.
The Rule of 25 times goes like this. Calculate your total monthly expenses. This includes everything from the food that you eat to all of the movie packages that you pay for, your rent or mortgage, and any car payment that you have.
When you have the total monthly amount, multiply that number by 12. This will give you the total of your annual expenses. If you bring home $5,000 a month, and your monthly expenses for all of your bills is $4,500, your annual payments would be $4,500 * 12 or $54,000 annually.
The annual expense is the number that we want to hone in on. This is the number that we are going to be basing how much we need to live comfortably in retirement. When you have your yearly expense number, you are going to go ahead and multiply this by 25.
So in the previous example, we would take the $54,000 in annual expenses and multiply by 25, which would bring us to $1,350,000. This is the amount that you need to be able to retire comfortably. This also happens to play off of the 4% rule we will discuss later. 4% of $1,350,000 is also equal to $54,000.
Our goal here is to get you to that retirement number. It doesn’t matter if it takes you 10 years or 50 years to get there. When you’ve reached that number, you will no longer be working because you have to. Now you can work because you want to. Congratulations! You have just reached the level of “F U” Money.
Can you imagine what that would feel like? To be in a situation that you no longer have to work to survive? You have reached what we call true freedom.
That doesn’t mean that you must quit your job. What it does mean is that you’re free to explore what you would like to do. Maybe you want to drop down to part-time work and start up your own business venture. Perhaps you want to travel the world. It is all open to you now.
Now, here is the thing. This isn’t set in stone. This is to give you an estimate as many factors go into what you will need. If you decide to massively increase your debt, the retirement number changes. If you start building residual income, the amount you need to withdraw decreases, which decreases the amount you need to retire.
The point of this is to explain that it shouldn’t be scary. Anyone can retire comfortably, even early. It would be best if you built out a financial roadmap to stay on track. The hardest thing isn’t retiring. The hardest thing is building a disciplined approach to achieving your goals and actually sticking to them for the long term.
Now that we have your number, you can start working backward to see how long it will take to get there. Take a look at an investment calculator and then plug in numbers that you can afford to invest. Then take a look at a conservative return rate to see how long it will take to get there.
How Do I Get There?
If you can save 40 – 50% of your income, which to many seems impossible, then it isn’t unheard of that you would be able to retire from having to work within 10 years.
Let us take a look at an example. If you live here in Maine and make around 100k as a family, your net take-home is around $71,000. That means you would have roughly $35,500 that you could use to pay your debts or approximately $2,960 per month. That means you have the same amount to invest each month if your debts are 50% of your take-home pay.
If this works as intended, and your expenses equate to $35,500 a year, that means you need $887,500 to reach your retirement goal. It will take you 14 years to save up $911,746 by investing $2,960 a month at 8% returns. If you’re 35, that means you can retire under 50. At 20? At 34.
Now, of course, I know that many other factors will go into this. One major flaw that I feel comes from the FIRE community is what happens if there is ever a catastrophic event. Suppose you were to get cancer or be hospitalized for an extended period. In that case, it could completely wipe out your portfolio, just paying for medical expenses if you aren’t properly protected.
The argument I usually hear from the FIRE community about a black swan event like this is that they would just go back to work. I only bring this up because even if you manage to acquire the retirement number you need, it isn’t one hundred percent foolproof.
Woo, alright. We made it through the first part of the post. Are you still with me? Great.
Now we take a look at the second half. As I mentioned, the laws are calculated similarly. When applied to someone investing for their FIRE goals, it is interchangeable to the 25 times rule.
The 4% Rule
What I am talking about is the 4% rule. This was first concocted almost 26 years ago by a financial advisor named Bill Bengen out of Southern California.
The percentage that he came up with was meant to serve as a worst-case scenario so that you would never outlive your retirement assets. It is essential to know that by taking the 4% out of your retirement funds, you could see that your assets continue to grow throughout retirement. This means when you pass away, your retirement assets could be worth more than when you started.
The way to look at the Rule is this. Every year, you want to sit down and see where your portfolio is. Let us say you are retiring this year, and you have managed to save up $500,000 in retirement assets. You would be able to take out $20,000 from that portfolio conservatively and not be at risk of blowing up your assets.
This is a vital thing to know. There is nothing scarier than being in retirement and not having any money that you can fall back on. Now, this $20,000 would be in addition to social security if you are lucky enough to get that. I’m not sure that it will be around when I am at the age I can take it, so I’m not banking on it.
Every year, you will want to re-evaluate your portfolio before you take your distributions for the year. A great time I’ve found to take the snapshot is December 31st of the previous year. This is because you may have a required distribution you need to take anyway, and you’ll want to make sure you at least cover that amount.
You’re probably wondering what a required minimum distribution even is. Maybe you haven’t heard of that before.
Well, there was a recent change due to the SECURE Act that was passed in 2020. The required minimum distribution beings now at age 72. If you happen to have a traditional IRA, there are tax advantages that go with it. Take a look at this article about IRAs if you’d like to know more about those advantages.
Anyway, Uncle Sam definitely wants access to those assets. You originally were able to deduct those assets from your taxes, and they grow tax-deferred. For every gimme, there is a gotcha. Where the IRS gets you here is that now 100% of your traditional IRA becomes taxable. If you haven’t started to take those distributions by age 72, the government forces you to.
Guess what happens if you don’t take your RMD for the year? The IRS hits you with a lovely 50% penalty. Now, it is understood that we are all human. We make mistakes. If you self-report the blunder and have it quickly rectified, they may be willing to provide some relief for that.
But now we are entirely off-topic, back to the 4% rule. So long as you keep your portfolio invested in the markets, you should be able to outpace the 4% rule. You could essentially have your assets grow at a rate greater than your withdrawal rate. If this happens, you’ve just given yourself a raise. The trouble arises from individuals who decide to transition 100% of their retirement assets into a fixed account.
With 10-year bond rates hovering around 1% here in January of 2021, you’re not going to get a lot of bang for your buck. To put that into perspective, it would mean with $1,000,000, you would make a whopping $10,000 in interest.
I’m not here to preach to you about staying invested. I know that each individual has their own risk tolerance level. You need to stick to what you’re comfortable investing in. Just know that if you pull your assets out of the market, it will be hard to find returns that outpace your withdrawal rate.
And that is really the name of the game. You don’t want to be in your 70’s and 80’s and running out of cash. This is why I have always been a massive fan of broad market index funds like the Vanguard Total Stock Market Index. This will cover the market at large, and it is also a low-cost investment strategy. To learn more about why investing in index funds is important, take a look at this article here.
Keep in mind that I am not making a recommendation here and you need to do your own research. There are many good companies out there that I like. This is merely an example to give you an idea of what to keep an eye out for.
With the 4% rule, it is acceptable to take out more. Even with a 0% return, your assets would last you 25 years. If you pull out more in the good years, it won’t significantly impact the overall portfolio. The damage happens when you pull out large cash withdraws, and the market is down considerably in the year.
This can have a compound effect on the losses, and you may never recover from it. This is why I always recommend having a year or two worth of cash reserves in a liquid account to pivot to in a market downturn.
In essence, don’t overextend yourself. But suppose you need to take a larger distribution due to an emergency. In that case, it is better to do it in a strong market than it is to do it during a market downturn.
Final Thoughts
To wrap up, we talked about the 25 times rule for calculation your retirement goal number quickly and reaching FIRE. We also discussed the 4% rule and how you can use that to your benefit when you’re in retirement. If you’re still in the wealth-building stage, the numbers are interchangeable – but if you’re winding down and entering retirement, go with the safe bet of 4%.
As always, I hope this was valuable. If there is anything that you would like more clarity around or if you have any questions, please comment below!
Disclaimer: Just My Little Mess does not provide tax, investment, or financial services and advice. The information is presented without considering the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.