IRS Withdrawal Calculation Offers Alternative to Standard 4%

Basing withdrawals on life expectancy has two significant drawbacks, she continues. First, the calculation involves applying a sophisticated equation, which may be beyond the capacity of many. Second, retirees face a high probability—a 50% chance—that they will outlive their savings.

Lastly, under the 4% rule, the retiree each year withdraws 4% of the initial balance. The advantage is that the retiree has a low probability of running out of money. The downside is that such a rule does not permit retirees to periodically adjust consumption in response to investment returns, she warns.

“An alternative strategy is to base withdrawals on the RMD rules,” Munnell explains. The IRS makes no claim that the RMD, which is designed to recoup deferred taxes, is the basis of an optimal draw-down strategy. Yet an RMD approach satisfies four important tests of a good strategy.”

First, like other rules of thumb, it is easy to follow. The IRS stipulates withdrawal percentages based on tables of life expectancies. Second, it allows the percentage of remaining wealth consumed each year to increase with age, as the retiree’s remaining life expectancy decreases. Third, as consumption is not restricted to income, the household is less likely to chase dividends and is more likely to have a balanced portfolio. Fourth, consumption responds to fluctuations in the market value of the financial assets, because the dollar amount of the drawdown is based on the portfolio’s current market value.

“To determine which real-world strategy would produce the best possible outcome, the paper compares the various rules of thumb, including the RMD approach, with an optimal wealth draw-down strategy,” she concludes. “The results show that the RMD approach does about as well as the other strategies and actually outperforms the 4% rule. Given that it also has the four desirable characteristics described above, the RMD approach should be viewed as an alternative viable strategy.”