This article is an excerpt from the Shortform book guide to "The Simple Path to Wealth" by JL Collins. Shortform has the world's best summaries and analyses of books you should be reading.
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Do you plan to live off investments when you retire? How much money can you safely withdraw from your portfolio each year?
According to financial expert J. L. Collins, withdrawing 3% or less a year is as close to a safe bet as you can get. Collins’s personal strategy, however, is to withdraw around 5%, but to reduce withdrawals to 4% if the market drops. He says it’s also important to be flexible—if you can reduce your expenses when necessary, find temporary work, or move to a cheaper area, you can add a layer of security regardless of the withdrawal rate you choose.
In this article, we’ll take a look at Collins’s advice on how to live off investments, how much money to withdraw, as well as the mechanics of setting up your withdrawals.
How Much Money Can You Safely Withdraw?
The common recommendation of 4% a year (the 4% rule) is one piece of retirement advice that actually works. The rule was developed in 1988 by three professors who ran computer simulations to test the impact of different percentage withdrawal rates on various portfolios over a 30-year period. They updated the research in 2009 (adding another 21 years). They found that:
- Over 30 years, a portfolio split 50-50 between stocks and bonds, with a 4% withdrawal rate adjusted for inflation, remained stable 96% of the time.
- In 55 years, the portfolio lost ground only twice. In the other 53 years, it continued to grow robustly, meaning the holder could have withdrawn more than 4% without reducing the total.
Collins draws the following conclusions:
- The safest amount you can withdraw is 3% or less.
- If you hold 75% of your assets in stocks and 25% in bonds, you can safely withdraw under 4% a year and take an increase for inflation.
- If you don’t take annual inflation increases, you can withdraw up to 6% a year while keeping a stocks-bonds balance of 50-50.
- The study’s authors say you can withdraw as much as 7% if you watch the market and, if it drops, cut back on spending and withdrawals until it recovers.
Setting Up Your Withdrawals
The mechanics of withdrawing 4% a year from your investment portfolio are simple:
- Request that your investment firm transfer to your bank account a certain amount of money weekly, monthly, or however often you choose.
- Also request that capital gains, dividends, interest be transferred to your account as they are paid.
- Or, log in to the website and transfer money yourself anytime (or combine automatic and manual transfers).
Beyond the mechanics, you should determine some guiding principles for withdrawing your 4%. Below are Collins’ principles on how to live off investments:
- In creating a 75-25% stocks-bonds allocation, he looks at all his funds in total, not the allocation of individual accounts.
- He reinvests dividends, capital gains, and interest in his tax-advantaged accounts.
- He has his dividends, capital gains, and interest from taxable accounts sent to his family’s checking account.
- He allow his tax-advantaged investments to grow tax-deferred as long as possible.
- While Collins and his wife are under age 72, they’ll move as much money as they can from their regular IRAs to Roths, while staying in the 12% tax bracket.
- When Collins and his wife turn 72, RMDs will replace what they were withdrawing from the taxable account, giving the taxable account a chance to grow again.
Spending Your Money
Collins’s guidelines for spending money in retirement are:
- To give your investments as much time as possible to grow, spend any money you are still earning first.
- Spend down any miscellaneous assets you have, such as individual stocks, but do it gradually to minimize capital gains taxes.
- Withdraw and spend money from your taxable account until you reach age 72 and have to take RMDs.
- Calculate your withdrawal rate based on the total in all your accounts, not just the one you’re withdrawing from.
- Keep a spreadsheet and log your expenses by category so you can see where to cut if the market plunges.
Adapt these basic ideas to your circumstances. Also, reassess your withdrawal plan once a year while you’re reviewing your asset allocation.
Giving to Charity
When planning your retirement, you may also want to consider the benefits of giving. In addition to the personal satisfaction you get, giving also has tax advantages.
If you itemize your taxes, you can claim a tax deduction for giving. Beyond that, Collins and his wife created a charitable foundation using the Vanguard Charitable Endowment Program. Under the program:
- You can start a foundation for a minimum of $25,000, and get a tax deduction the year you fund it.
- If you have assets that generated taxable returns, you can transfer them to the foundation to avoid capital gains taxes and get a tax deduction for their market value.
- To minimize RMDs, you can transfer money from a tax-advantaged account into your foundation tax-free.
- By choosing from various investment options, you can ensure your charitable nest egg grows tax-free until you allocate it. You can add money at any time.
When you allocate your charitable funds, you’ll have the most impact if you focus on a small number of organizations or causes. Remember to research organizations before you give.
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- A simple road map to achieving financial independence and a secure retirement
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