Your House Doesn’t Count Towards the 4% Rule

The 4% states you need your yearly spending times 25 to retirement. One question I get a bunch is around the idea of "what assets are included" in that 25x number. Spoiler: It's not your house.

. 6 min read. Financial Independence, Personal.

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In the financial independence / retire early world, the 4% rule is kind of a big thing. The core idea of this rule is simple: save up enough money so that you can withdraw 4% of the funds to live off each year. For example, with $1,000,000 saved up, you could withdraw $40,000 according to the 4% rule. You could continue withdrawing that same amount, adjusted for inflation, for at least 30 years and still be OK.

Trinity & Bengen Studies

There have been multiple studies, most notably the Trinity Study and the Bengen Study. Both of these studies look at historical stock market data and inflation numbers to predict what safe withdrawal rate would be over time to last at least 30 years.

In the Trinity Study, a portfolio of 75% stocks, 25% bonds stood a 98% of lasting 30 years – the highest asset allocation tested during that time period. As for the Bengen Study, I’ll let him explain it from his Reddit AMA last year.

The “4% rule” is actually the “4.5% rule”- I modified it some years ago on the basis of new research. The 4.5% is the percentage you could “safely” withdraw from a tax-advantaged portfolio (like an IRA, Roth IRA, or 401(k)) the first year of retirement, with the expectation you would live for 30 years in retirement.

After the first year, you “throw away” the 4.5% rule and just increase the dollar amount of your withdrawals each year by the prior year’s inflation rate. Example: $100,000 in an IRA at retirement. First-year withdrawal $4,500. Inflation first year is 10%, so second-year withdrawal would be $4,950.

Both of these studies have a few things in common:

  • They assume you’re invested in the stock market.
  • They assume you withdraw a small amount each year and pay taxes on it.
  • They assume you’re getting some dividends throughout.

What neither of these include are other assets – your home, car, artisan bird feeder or college education.

Use Investments Not Net-Worth

All of the above criteria used by these studies rely on using your investment total, not your net-worth total. Your net worth may be huuuge, but unless you have 25x your yearly spending (which would give you a 4% withdrawal rate), you won’t have the capital needed to retire early. I hate to be the bearer of bad news for some hoping to retire early, but your house shouldn’t be taken into account in this. Houses go up in value though (well, mostly) so why not include them?

Homes Fluctuate Differently

I can tell you from my own experience buying a house in 2006 that they don’t appreciate in the same way as stocks. I bought a house (and also sold one) at quite possibly the worst time in US history to do so. When we sold our house 11 years later, it was still worth 25% less than we paid for it. In the end, we put down about $50k on the house and sold it for $50k less than we bought it for.

If we had instead invested that $50k in 2006 how would it have done?

  • $50k in Apple would be $1,050,000.
  • $50k in Vanguard Total Market would be $110,000.
  • $50k in Vanguards Target Date Retirement 2045 fund would be $93,000.
  • $50k in Vanguards Total Bond Market would $77,000,
  • $50k in my house was $0.

My entire down payment was wiped out, and never recovered during this time. The difference here to me is that the actual money you’re putting into stock markets isn’t likely to go to $0. If it does, that means we’re probably living in a very quiet place without much going on where all global markets (and possibly countries) have collapsed.

For your down payment on your house to go to $0 is much more possible. Since you’re likely buying your house with a mortgage, you’ll be leveraging yourself to pay for it. It only needs to fall by the down payment amount to wipe out that capital. It’s the difference between falling 20% to lose everything and falling 100% to lose everything.

Small Withdraws Aren’t Possible

You also can’t partially withdraw funds from a house – unless you’re planning to get a reverse mortgage. If you’re retiring with a net worth of $1,000,000 and $900,000 is in real estate, what do you do when you need that cash? More than likely you’ll need to sell it. Taxes for home sales on your residence are actually surprisingly lax. You only need to pay capital gains tax on gains over $250,000 (filing single) or $500,000 (filing jointly).

In the event that you do need the funds from your house, that’s quite a large life change. If your capital gains are likely to be above the $250k/$500k numbers, you’ll likely need to plan on paying some takes.

Are You Diversified?

Owning a home is like owning a single stock. Even if the housing market is booming, it doesn’t mean you’re going to take advantage of it. For that, you’d need to be invested in a Real Estate Investment Trust (REIT) fund that tracks a large segment of the market. For most homeowners, that is their biggest asset. With that comes risk that something will happen – to the home, to the neighborhood, to the city, to the county, to the state, to the area of the country, or the country as a whole.

The Trinity study landed on a portfolio of 75% stocks, 25% bonds as the sweet spot. Bengen’s study found a number between 50% – 75% stocks as well. Neither study includes your house in those numbers. I’m not suggesting that it won’t work, just that these studies haven’t taken into account the value of your house.

My House is Already Up, Can I Use It?

If you’re planning to move soon, maybe. If you’re planning on staying in it long-term and retiring there then no.

Let’s say you already have a lot of equity in your home, and you’re planning to move in 10 years. During that 10 year period, you’re going to be taking on risks unknown to the Trinity/Bengen studies. I can’t say how it’ll turn out, but I can say it didn’t work too well for me. I hope things go better for you!

What Should I Do With My Home Then?

Even though I wouldn’t include it in your 4% numbers, homeowners have one major advantage – being able to forecast their spending! After your home is paid off, you no longer need to pay a mortgage or rent each month. This allows you to lower your yearly spending by a bunch when then lowers the amount you need.

Mr. Money Mustache is a bit famous for this. He spent $30,000 in 2016 (excluding blog business-related spending and travel). What’s not in this $30k number is any housing since it’s paid off. I tried running some of the same numbers myself – looking at what would happen after I paid off my house and lowered expenses. It did help raise the confidence level in some models.

Using the 4% Rule with Lower Future Expenses

There is no super-easy formula for what happens if your expenses go down in the future. The most common shortcut is to raise your safe withdrawal rate up from 4% to something like 4.5% if you know your expenses will drastically decrease in the future. I’m not a huge fan of this method, as it lacks the math behind to verify what the SWR should be raised to.

One tool I used to run the numbers was Personal Capitals (free affiliate link, but we’ll both get a $20 Amazon Gift card!) Retirement Planner. With it, you can model these more complex routes by creating expenses that start at a specific date and only go until another specific date in the future. This allows you to create timeboxed spending that only occurs for a set time in your life. This is where I would include your home in your calculations (if you’re planning on living there long term).

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Personal_Capital_-_Retirement_Planner-Retirement-spending
Set your retirement spending to a number that doesn't include your mortgage.

This is important to set here without your mortgage if you own a house. If you were to set this with your mortgage payment, then Personal Capital is going to assume that’s part of your growing expenses every year. Instead, create it as a separate spend.

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Personal_Capital_-_Retirement_Planner-mortgage
Create a separate "Spending Goal" for your mortgage. Set it to start at your retirement date and stop at the date your mortgage is paid off.

This ability to create a spending event that starts at a set time and stops a set time is one of the killer features of Personal Capitals Retirement Planner to me. In addition to the mortgage, you can use this for lots of other expenses:

  • Mortgage Payments
  • Healthcare until you’re 65
  • Car expenses
  • Buying a new car every (x) years (15? 25?)

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Your spending list will now contain spending for future times in your life, allowing you to plan your retirement more accurately!

What I really like about this setup is that the more information I put into it, the better the estimates become. When I realize that some expense will be temporary rather than a permanent addition to my spending then I’ll include it here as a temporary expense. If it’s more of a fluctuating expense, I include that in my main “Retirement Spending” category based on my financial independence with options number.

You can use this same technique if you plan to sell your house later and move to a different one. At that time you’d have some additional income from the sale, and your yearly spending would likely change with your new accommodation. I don’t have a house anymore, but when I did, this is the technique I used to include it in my numbers. If you want to check it out, sign up for a free Personal Capital account and let me know how it goes.

If you own your home, how do you include your future planning? 

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