5 min read
The 4% rule is a commonly used rule of thumb for retirement spending. It’s a simple concept: add up all of your investments, then withdraw 4% of that total during your first year of retirement. In each year that follows, bump up the amount you withdraw to account for inflation. By following this approach, there is a high probability that you won’t outlive your money during a 30-year retirement.
For example, suppose your portfolio is worth $1 million when you retire. Following the 4% rule, you could withdraw $40,000 in your first year of retirement. To keep up with 2% inflation, you could withdraw $40,800 in year 2. You could keep following this approach for the next 30 years with a high likelihood that you wouldn’t outlive your money.
The bottom line of the 4% rule is this: It provides you with a passive income stream that covers your living expenses.
However, because the 4% rule has become so common and widespread in personal finance, it has become easy to forget that this rule only offers one way to cover your living expenses.
The Many Ways to Cover Your Lifestyle Expenses
Every individual has a certain amount of expenses they must pay for each year. This includes things like rent, utilities, transportation, food, insurance, etc. The allure of the 4% rule is that it offers a way to pay for these expenses in a completely passive manner.
Using the 4% rule, if you have a portfolio worth $1 million, then you can support a lifestyle of $40k/year simply by withdrawing $40k from your portfolio each year. If you have a portfolio worth $2 million, then you can withdraw $80k each year.
The beauty of this approach is that it doesn’t require you to work at a job you hate just to earn money to cover your expenses. You can simply log on to your financial account, click a button to sell off some stocks or bonds, and use that cash to pay for rent, utilities, transportation, etc.
The 4% rule offers an income stream that has the following two features:
- Passive – you don’t have to actively work to earn this income
- Enjoyable – you don’t have to do work you don’t enjoy to earn this income
While it’s nice that this income stream is passive, what’s far more important is that it’s enjoyable.
This brings up an important point: your goal should be to earn enough income in an enjoyable (or at least semi-enjoyable) way to cover your lifestyle expenses. Following the 4% rule is one way to do so, but it’s not the only way.
Blending Active & Passive Income
Once again, consider someone who spends $40k per year. Using the 4% rule, they could cover their yearly expenses with a portfolio worth $1 million.
But they could also cover their yearly expenses by withdrawing 4% of a portfolio worth $975k (which provides $39k in passive income) and by earning $1k per year through active income.
Or they could cover their yearly expenses by withdrawing 4% of a portfolio worth $875k (which provides $35k in passive income) and by earning $5k per year through active income.
Using this logic, each $1k you are willing to earn each year in active income is $25k you don’t need to accumulate in your portfolio.
The following table shows the various ways that you could cover $40,000 in yearly lifestyle expenses by withdrawing 4% from different portfolio sizes and by earning the rest in active income:
The following chart helps visualize these numbers:
On the top left end of the chart, we see the scenario where someone could cover $40k in yearly expenses by withdrawing 4% of a $1 million portfolio each year and by earning $0 in active income.
On the bottom right of the chart, we see the opposite scenario where someone could cover $40k in yearly expenses by earning $40k purely in active income without any help from a portfolio.
Directly in the middle of the chart, we see the scenario where someone could cover exactly half of their $40k yearly expenses by withdrawing 4% each year from a portfolio worth $500k and by earning $20k each year in active income.
The Passive & Active Income Calculator
The following calculator can you help you find one of two things:
- Enter your yearly expenses and your portfolio size. Leave “Yearly Active Income” blank and calculate the yearly active income needed to cover your yearly expenses.
- Enter your yearly expenses and a hypothetical amount of yearly active income. Leave “Portfolio Size” blank and calculate the portfolio size needed to cover your yearly expenses.
Note: The calculator assumes you will withdraw 4% of your portfolio each year.
Finding the Right Blend
When I first discovered the FIRE (Financial Independence, Retire Early) community, I thought the 4% rule was the only way to gain financial freedom. I had to save up 25 times my yearly expenses so that I could have a portfolio large enough to passively support all of my lifestyle expenses.
However, I’ve realized that it’s possible to cover my lifestyle expenses through a potential blend of passive and active income. Of course I’d like to build up my portfolio to a decent size, but I no longer think that I need a portfolio so large that it is my sole source of income.
In particular, I’ve found that I can earn income through blogging and stats tutoring, both of which require active work on my part, but both of which are enjoyable active income streams.
In fact, last month alone I earned nearly $2,000 in income outside of my day job. If I could earn that much each month, that would be $24,000 per year. And according to the calculator above, if I wanted to live on $40k per year, I would only need a portfolio worth $400,000 that I could withdraw 4% from each year to cover the rest of my expenses.
In addition, if I could grow my income outside of my day job to $40k per year doing stuff I enjoy, I wouldn’t even need a large portfolio to be able to quit my coporate day job.
Of course there are benefits to having a large portfolio. Namely, it provides a passive source of income, so I wouldn’t even have to think about how to earn money through active work. The drawback, though, is that it can take years and even decades to build up a portfolio that is large enough to support my lifestyle completely.
Should you build up a portfolio that can support 100% of your lifestyle expenses? Or should you instead built one that can cover 50% of your expenses and cover the other 50% through active income?
There is no universal correct answer.
The correct answer for you largely decides on your personality and your life situation.
Perhaps you’re someone who wants to quit their day job as soon as possible, so you’re okay with earning most of your income actively.
Or perhaps you’re someone who wants a large enough portfolio that you don’t have to worry about earning income in any active manner.
Either way, simply recognize that the 4% rule is only one possible path you can pursue financially.
My favorite free financial tool I’ve been using since 2015 to manage my net worth is Personal Capital. Each month I use their free Investment Checkup tool and Retirement Planner to track my investments and ensure that I’m on the fast track to financial freedom.
My favorite place to find new personal finance articles to read is Collecting Wisdom, a site I created that collects the best personal finance articles floating around the web on a daily basis.
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