The 4% rule: The Path to Financial Freedom.
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| The 4% rule: The Path to Financial Freedom. |
The special aspect is that there isn't a fixed amount that works for everyone to never have to work again. Instead, the 4% rule takes into account your financial situation and sets a goal for financial freedom. Here, you will learn how the 4% rule works and how much you need to have enough for the future without further income...
What is the 4% rule?
The 4% rule is a mathematical formula that allows you to calculate how much money you need to no longer have to work for the rest of your life and live solely off your capital.The 4% rule is linked to the concept of frugalism, which aims to achieve financial independence as early as possible and, for example, retire at 40 years old.
Those who adhere to the 4% rule should be able to live without additional salary or income. They can then use their assets and interests to maintain their current (or future planned) standard of living.
Financial freedom is a significant goal. The idea is that you need a large enough starting capital so that you have enough money over decades without a monthly salary from an employer, without the risk of your savings running out and being left without money.
how do you calculate the 4% rule?
The 4% rule is surprisingly simple:You need 25 times your annual expenses as starting capital.
If you have saved and invested this amount, you can, according to theory, cover your annual expenses for the rest of your life without going bankrupt or facing financial difficulties.
How long can you live on 100,000 $?
Can you relax with 100,000 $ in the bank? That's a misconception. Of course, it's a nice sum, but according to the 4% rule, you can only use 4,000 $ annually from it – otherwise, the amount will quickly diminish. Assuming your standard of living is 45,000 $ per year, you won't get far. In this case, the capital income is a nice supplement, but without additional income, you can only live off 100,000 $ for about two years – depending on your expenses.Where Does the 4% rule Come From?
The 4% rule is the result of the so-called Trinity Study, where professors from Trinity University in Texas in 1998 asked the question: How much money can be withdrawn annually from existing assets without risking insolvency? The researchers invested fictitious assets (in stocks and bonds) for 30 years.The findings: Those who used 4 percent of their savings annually still had money left in their accounts at the end of the period. The 4% rule has since been expanded. Researchers now believe that withdrawing 4 percent per year from your assets can last much longer, potentially even indefinitely.
4% rule Calculator: Example
Suppose you have an initial capital of one million $ in your account. According to the 4% rule, you can withdraw 4 percent, or 40,000 $, each year to cover all expenses. In the next year, you can withdraw the same amount again, adjusted for inflation. For example, with an inflation rate of 3 percent, you can withdraw 41,200 $ in the second year (the calculation: 40,000 $ multiplied by 1.03 = 41,200 $).You pay yourself a salary from your assets. Instead of receiving a monthly paycheck from an employer, you can pay yourself the corresponding amount from your capital.
How Does the 4% rule Work?
Behind the 4% rule is what Albert Einstein supposedly called the eighth wonder of the world: compound interest. The idea of financial freedom, where you never deplete your initial capital despite regular withdrawals, works because you earn interest and compound interest by investing your money. Instead of earning money yourself, you let your money work for you.With a good investment strategy and corresponding returns, the 4% rule can ensure that not only is there money left over, but the capital can remain constant or grow over the years, as interest and dividends exceed your expenses.
Requirements for Implementation
However, the 4% rule requires a certain level of discipline. You must first accumulate and invest the necessary initial capital, which often requires corresponding frugality and sacrifices. In the long term, the concept only works if you do not significantly increase your expenses.This may sound straightforward but is not so easy. After all, at this point, depending on your situation, you may have over a million $ in capital available. Nevertheless, you must adhere to the 4% rule and live on 40,000 $ a year – a monthly salary of 3,333 $, even though you are essentially a millionaire. If you withdraw much more, the money might run out.
Alternative: Variable 4% rule
To be even more certain that you will never run out of money using this method, you can use a variable version of the 4% rule. Here, you withdraw not 4 percent of the initial capital but from the current assets. Did your investments yield a good return in the first year, increasing your account balance from 1,000,000 $ to 1,050,000 $, despite withdrawing the annual 4 percent? Then you can use 4 percent of this amount in the second year – which amounts to 42,000 $.Conversely, if the financial markets performed poorly, you may have less available in the second year, but your frugality can counteract the downturn.
Financial Independence: It Depends on How Much You Spend
An essential factor in the 4% rule: What matters is solely how much you spend. No fixed amount guarantees financial freedom for everyone. One million, three million, or even five million $ – what is enough to be completely financially secure and never have to work again? This can be the subject of lengthy and heated discussions because everyone has different expectations.The crucial question is: How much money do I need? It doesn't matter how much money someone has and how large the number in the account is. It always comes down to how high the expenses are.
How Long Can You Live on One Million $?
Imagine you win one million $ in the lottery – how long can you live on that? Most people can live for many years with such a large amount. For some, it corresponds to what they earn over their entire working life. Others buy three cars, go on a world trip, throw a big party, and have nothing left after three months. The same initial capital, two entirely different spending habits.That's precisely why there is no universal amount for financial freedom. The 4% rule takes these individual differences into account. While one person is happy with 35,000 $ a year, another needs 60,000 $. This must be determined in the initial analysis of annual expenses. Accordingly, the required starting capital increases.
How Much Money Do I Need to Never Work Again?
Now you know the theory and mathematical foundations. Using the 4% rule, you can determine how large your savings need to be to never work again while still being financially secure.These three simple steps show you how much money you need and how to implement the 4% rule:
1. Analyze Expenses:
First, you need a concrete number for your yearly expenses. Include all costs: rent, loans, insurance, car, contracts… Since you often don’t know exactly how individual costs will develop over time, it’s better to estimate the expenses slightly higher. This minimizes the risk of calculating with too small a budget.2. Forecast the Future:
An important point: Consider whether your expenses might increase in the future. Are you currently happy with 40,000 $ a year? Will that still be the case in ten years? What about family planning, which brings additional costs, not just for the child, but also for a larger apartment or house? Accounting for these things now will lead to fewer problems later.3. Determine Initial Capital:
In the final step, multiply your calculated annual expenses by the factor of 25. So, if you plan with 50,000 $ a year, you need 1.25 million $ to never work again and still be financially secure. If you need 100,000 $ a year, the starting capital for financial freedom increases to 2.5 million.Just calculate it yourself: take your annual expenses—or your annual salary for an easier calculation—and see how much you need according to the 4% rule to never work again.