Motley Fool Answers' August Mailbag: The 10 Times Annual Income Rule vs. the 4% Rule

Summer is just about over, but we expect most Motley Fool Answers listeners didn't "sell in May and go away" -- you've been keeping up with matters of finance and investing all along...right?

However, if you happened to take a break from thinking about your money during beach season, you might have missed a few of Alison Southwick and Robert Brokamp's monthly mailbag shows. In which case, you wouldn't have noticed that Ross Anderson -- certified financial planner from Motley Fool Wealth Management, a sister company of The Motley Fool, and a regular on the mailbag podcasts this spring -- took a break from his guest hosting duties as well, so that other Fools could get their time in the sun. Now, he's back to help the podcasting duo address another batch of listener queries.

In this segment, they unpack a question from Joe, who is a bit confused by how the classic 4% rule for annual retirement account withdrawals squares with the common advice to have 10 times your annual income saved up by the time you quit working. To quote Darth Vader, "There is no conflict" -- and the Fools explain why.

A full transcript follows the video.

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This video was recorded on Aug. 28, 2018.

Alison Southwick: The next question comes to us from Joe in Denver. "My question is about two seemingly conflicting rules of thumb about how much someone should have saved for retirement. The first says that you should have 10 times your salary saved by retirement. The second says your annual withdrawal rate in retirement should be about 4%, which implies you should actually have saved 25x your salary by retirement. That's a huge difference. Am I missing something? Can you straighten this out for me?"

Robert Brokamp: Joe, the "4% rule" is just about how much you can safely withdraw from your portfolio in the first year of retirement, and then you would adjust that dollar amount every year for inflation. It doesn't factor in your other sources of income. It doesn't factor in how much your income needs will drop in retirement. It's just about how much you can take from your portfolio.

If you were to say that you needed $50,000 a year from your portfolio in retirement, you can multiply that by 25 to get $1.25 million, which is a rough goal based on the 4% rule, and I say rough because there are actually some shortcomings with this whole 4% rule which maybe we'll get into one day in this very podcast. For now, it's a good rule of thumb.

Now the "10x your salary" rule of thumb is very different. It factors in how much you'll receive from Social Security as well as how much income needs will actually drop after you retire. Most people can get by on 70-80% of what they needed while they were working largely because [1] you're no longer paying payroll taxes and [2] you're no longer contributing to your 401(k). There might be some business-related or work-related expenses that go away. But basically many experts have analyzed this, put all this together, and come up with this rule of thumb that says you shouldn't retire until you have 10x your household income saved up.

Now other people have looked at it and come up with other numbers. Some put it at 12. That's where T. Rowe Price is, and I think their analysis is pretty good because the amount that you need saved earlier in life is lower, but they expect you to really ramp up your savings later in life, which I think is realistic for people. Regardless, I think shooting for about 10-12 [times] your household is what you should have before you retire.

That said, when it comes to the point when it's actually time for you to decide, don't rely on rule of thumb. Definitely spend the money to see a good, qualified fee-only financial planner to decide whether you are actually ready to retire.

Ross Anderson is an employee of Motley Fool Wealth Management, a separate, sister company of The Motley Fool, LLC. The information provided is intended to be educational only, and should not be construed as individualized advice. For individualized advice, please consult a financial professional. The Motley Fool has a disclosure policy.