Tax and the 4% Rule 

How should we consider tax when using the 4% rule for early retirement calculations?

I have a plan.

A financial road map, leading me from where I am now to where I want to be. It ignores get rich quick schemes and the latest crypto craze and takes the shortest route I know that will get me there in one piece.

I have been quite proud of this plan. Being a spreadsheet geek, I have spent many a happy hour setting it up, tweaking it and generally just playing with the numbers. It has different sections for different scenarios and is artfully colour coded. I consider it a work of great beauty and I often look at it just to relax. (Some of you will understand…..!).

My Financial Background

Since you don’t know me from Adam, let me explain a little bit about myself. I qualified as a Management Accountant back in the day and have spent the twenty five or so working years of my life in a variety of finance or accounting roles – based in the finance department of a company of one sort or another. I am not a financial advisor or financial planner, but I am comfortable with most things money related.

I have always been reasonably careful with my own money but in recent years I have woken up to the idea of having money work for me. I now treat personal finance as a hobby – I read books and blogs and listen to podcasts and invest many hours a week in this continuing education, soaking up the wisdom of all those willing to share their experience.

So imagine my horror when I discovered a flaw in my beautiful plan. A big, black, ugly tax-shaped flaw.

The 4% Rule

My error revolves around the 4% rule.*

For those not familiar, in simple terms the 4% rule is a guide to help you recognise when you have reached financial independence.

When is your savings pot big enough that it can support you without the need for any further earned income? The 4% rule suggests that you have enough when you have 25 x your annual expenses invested. You can then “safely withdraw” 4% of this in the first year (increasing the amount annually by inflation) and have enough to live on for the rest of your life.*

It is assumed that average investment returns over the long term will be comfortably higher than the 4% you are withdrawing, such that you don’t eat into all of your capital.

What About Tax?

So – save and invest a portfolio worth 25 x your annual living expenses and you are financially independent. That is the common wisdom and what I had been diligently working towards.

As an example, let’s say living expenses are 2k a month for a comfortable lifestyle. The investment pot needed for financial independence would be 600k (2k a month x 12 months x 25). Right?

Sadly it’s not that straightforward 😦

Be honest, if somebody asked you how much you spend each month would you include tax in that list? I wouldn’t – and at the beginning of this journey, I didn’t. Perhaps the self-employed are at an advantage here, but for those of us who are employed, our employer takes care of our taxes.

When we think about our monthly spending, tax is not even on the radar. Our tax has already been deducted before that money hits our bank account. And unless we have any income streams outside of our employment, we really don’t have to think about tax at all.

Perhaps I am slower than most but I was a few months into my financial independence quest before the penny dropped. Even completing my annual tax return and having an additional payment to make didn’t lead me to think of tax as a “living expense”.

Definitions Affect the 4% Rule

Although you can employ strategies to be as tax efficient as possible, you can’t avoid it. When it comes to retirement savings it is a case of choosing whether to pay tax now or pay it later.

Pay Tax Later

It is possible to save and invest out of pre-taxed income. Pension contributions made from your salary before tax is deducted is a way of achieving this. Traditional advice for those intending to retire at standard retirement age would be to maximise contributions to these investments, with the assumption that the tax you pay while working may be at a higher rate than the tax you will pay in retirement. You can also enjoy the benefits of compounding on a larger base amount.

When you eventually start to withdraw from these investments, (subject to any tax-free lump sums and personal allowances that may exist) you will then pay tax at your standard rate.

To receive the 2k a month for living expenses in our example, we will need to withdraw more, pay the tax and receive the net 2k.

This will drain our investment fund quicker than expected. Which means that if we are following the 4% rule, the savings target we need to reach is higher than it may at first seem. (Using UK tax rates and personal allowances, it would be over 75k higher than we originally thought).

adult art conceptual dark

Pay Tax Now

An alternative is to save and invest using money that has already been taxed. In the UK at time of writing, we can save up to £20k a year into an ISA. All interest, gains and withdrawals are tax free. The advantage here is that there is no minimum age before you can access these funds and so they are particularly useful for those seeking early retirement.

In an extreme case, if all of the income needed in our example was to be taken from this pot, we wouldn’t have to think about tax at all and our original assumption of 600k would be just fine.

blur color conceptual cube

The 4% Rule is a Guide Not a Bible

When I first discovered the 4% rule it changed my whole outlook on life. It allowed me to apply logic and reasoning to saving and investing, and gave me faith that once I hit a magic number in investments, I could be free.

But it is nowhere near an exact science and we need to be careful with definitions. The reality for most people will be a mixture of pre-tax and post-tax savings – income from various sources, perhaps rental income or part-time income too. And how we account for these in our calculations can cause big swings in the target number.

We all need a goal. We all need something to work towards to measure our progress and stay motivated and we can use the 4% rule as this goal or as a guardrail. Just don’t take it as gospel.

Join the Discussion

Was it just me that found a “rule” and clung to it? There are many retirement calculators freely available – do you think about the assumptions behind them? Do you have a fixed FI number in mind or is it more about a fixed date for you? Are you comfortable with broad based assumptions or do you model your numbers more accurately? Please let me know in the comments.

 

* There are several studies supporting safe withdrawal rates; one of the best known being The Trinity Study http://afcpe.org/assets/pdf/vol1014.pdf . This analyses different allocations between stocks and bonds and many time horizons.

 

19 thoughts on “Tax and the 4% Rule ”

  1. I also take the 4% rule with a grain of salt. While it’s a guiding principle, as you mention, there are drawbacks. For this reason I built my own savings calculator specific to my situation here in Canada (I.e. specific provincial and federal taxes, and proper treatment of taxation by account. We have some non-taxable vehicles like TFSAs). As for the 4% withdrawal rate, it’s only as good as the history used to project it. 4% provides enough margin if you assume future real returns net you 7% – 8%. But I’m less optimistic. I generally use in the ballpark of 3% – 3.5% for my projections at the moment!

    Liked by 1 person

    1. Hi – thanks for commenting. A lot of people are less optimistic it seems, in the same ballpark as you. I’m so burnt out I don’t know if I can take that much longer to get the extra savings needed though.

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  2. I’ve always thought the 4%rule is very Conservative myself.

    I understand the new wisdom is to use your pension last as it doesn’t form part of your Estate for iht purposes. In the early years when you are fit and healthy you’ll spend more. You’ll also take your 25% tax free allowance but potentially only withdraw some of this pot while using isas. This doesn’t use any of your personal allowance. You will no doubt also keep 3-5 years in cash to ride out any volatility. Inevitably as you get older you will spend less, either because of health or because you’ve done all the things you wanted to do in terms of long haul trips etc.
    So by the time you dip into your actual pension the tax won’t seem so bad. You’ve also got your various allowances such as the dividend allowance, savings allowance, 11k odd personal allowance etc etc.

    By taking bits out at the right time I don’t see an issue. I may be being naive though! I’m nowhere near needing to do it yet

    Liked by 1 person

  3. I’ve probably mentioned before but I won’t be following a 4% rule as I intend to partially deplete my capital as I draw down.

    Although I’ve sort of thought about tax, I’ve not really worked out the numbers pre and post 65, ie the ‘extra’ bit you’re talking about – it hurts my brain thinking about it so I would rather procrastinate for now!

    Up to the age of 65 (if I haven’t retired by then, I’d have failed epically in my FIRE journey!), my income will be from my SIPP, ISA and rental income. I intend to ‘juggle’ with these 3 to try to skirt under the tax threshold, ie not pay any tax at all. When my company pension kicks in at 65 (and then later, the State pension), I will be taxed, so I intend to pay as little as I am able to.

    Anyway, the 4% should be considered as just a guideline – I think models based on UK historical data show it to be closer to the 2.5 – 3.5% mark.

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  4. I think the 4% rule and tax impacts single FIRE seekers more than couples. My calculations for our leanFIRE do include tax inasmuch as I have thought about it. However we are unlikely to pay tax in the early years as we will capitalise on our tax free personal allowances and top up via ISAs. For a couple that is £23k ish, whereas a singleton it’s only £11.5k ish. £11k doesn’t get you too far in living a comfortable life as a retiree whereas £23k for a couple is perfectly fine.

    We will pay tax once final salary pensions kick in but the plan is to drawdown a substantial part of Mr2p’S SIPP before his FSP kicks in. He will pay tax initially due to the way HMRC work the tax on drawdown payments but it’s claimbackable (new word?!) within a few weeks. If/when state pension kicks in we will definitely be paying tax but we will be receiving much more so that is ok.

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  5. I am using the 4% as simply a guide/benchmark in my pre-retirement plans. I am goaling myself with a net worth of $2.1-2.2 million net worth (by 2023) before calling it quits. If I reach this goal then 3.5 – 4% withdrawal rate will be no problem for me, regardless of taxes as 95% of my assets will be held in taxable accounts anyway and I’ll live on dividend income, paying that lower tax rate (assuming a different administration doesn’t scare the tax laws up!).
    I’m very conservative and always ere on the side of caution so 3.5% withdrawal rate is more to my liking. 4% is reasonable during a bullish cycle but this cycle is long in the tooth and a setback or period of flat returns is due. The 3.5% rate is conducive to this period of an investment cycle.
    I like that you brought this subject up as taxes DO play a huge role in folk’s withdrawal plans and it’s probably not considered as it should be as I have a feeling most of the FIRE community will have the lions share of their assets in tax deferred vehicles, unlike me. Taxes will be a major consideration for them.

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  6. Thank you for posting, you’re absolutely right, not all savings are created equal and you’ll probably have some level of taxes in retirement

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  7. I was *so* glad to see this post – I get really irritated by the simplistic calculations shown on some blogs, which seemed not to take any account at all of the fact that drawdowns from pension pots attract income tax! So thanks for calming me down, lol.

    When it comes to UK pensions taxation, there is also an elephant in the room in the form of the Lifetime Allowance. A lot of people assume that they will not be affected by it. But it’s likely to be a real consideration for those who retire early with a healthy SIPP (or other form of DC or DB pension pot) and intend to leave it to accrue for a long time before they touch it.

    The rules around the Lifetime Allowance are very complicated, and are poorly explained in just about every consumer website I have seen (even the Money Advice Service and the PAS), so it’s worth putting in a bit of research so that you can accurately assess whether there is a real chance of your pot exceeding the limit. If it looks like a risk, you can take action well in advance to reduce the size of the pot – probably one of the few situations where it could pay to take proper pensions advice from a professional (I’m not one, by the way!)

    If you exceed the limit, you are taxed at 55% if you take the excess as a lump sum or 25% (plus income tax at your marginal rate) if you elect to take the money as income through something like an annuity. If you die, your estate has to pay interest on the excess at 55%, so that’s something to bear in mind too.

    I’m currently modelling various growth scenarios to see whether I shall get caught out by the limit at some point, and I have to say it is doing my head in! And, of course, a change of government might see further tightening of the limit, as many politicians seem to see private pensions as a rather tempting low-hanging fruit…

    Jane

    Liked by 1 person

  8. Hi Jane,
    Welcome! And thank you for your thoughtful comment. You make a good point about the lifetime allowance. I don’t think I will exceed the allowance but others that have commented on this blog likely will. Soul destroying to have built up that level of savings only to have it raided by the tax man. We are all encouraged to save as much as possible into pensions to get the tax relief without consideration of the lifetime allowance. ISAs are under-rated in my opinion for precisely this reason.

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    1. Yep I’m aiming to get up to about half a million then will slow down putting money in. I’m just building my outside of pensions saving (a recent inheritance has just boosted this thanks grandad to just over 100k which is a great start to the snowball. At that level fluctuations and growth really make a difference 10%is obviously 10k

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