How much money will you need in retirement? Two popular rules of thumb outline the answer.
The "Multiply by 25" rule and the "4 Percent" rule are often confused with one another, but they contain a critical difference: one guides how much you should save, while the other estimates how much you can safely withdraw.
Multiply By 25 Rule
The Multiply by 25 Rule estimates how much money you'll need in retirement by multiplying your desired annual income by 25.
For example: If you want to live on $40,000 per year in retirement, you need $1 million dollars in your retirement portfolio. ($25,000 x 25 equals $1 million). If you want to live on $50,000 per year, you need $1.25 million. To live on $60,000 per year, you need $1.5 million.
Why that much? This rule of thumb assumes you'll be able to generate an annualized real return of 4 percent per year. The rule assumes that stocks, over the long run (15-20 years or more), will produce annualized returns of roughly 7 percent. This is the return that investing legend Warren Buffet predicts the U.S. stock markets will experience through the next few decades.
Meanwhile, inflation tends to erode the value of the dollar at roughly 3 percent per year. This means your "real return" - after inflation - will be about 4 percent.
Read More: The Rule of 72 and the Rule of 115
4 Percent Rule
The 4 Percent Rule is often confused with the Multiply by 25 Rule, for obvious reasons - the 4 Percent Rule, as its name implies, also assumes a 4 percent return.
The 4 Percent Rule, however, guides how much you should withdraw once you're retired. As the name implies, this rule of thumb says you should withdraw 4 percent of your retirement portfolio the first year.
For example: You retire with $700,000 in your portfolio. In your first year of retirement, you withdraw $28,000. ($700,000 x 0.04 equals $28,000.)
The following year you withdraw the same amount, adjusted for inflation. Assuming 3 percent inflation, you should withdraw $28,840. ($28,000 x 1.03 equals $28,840.)
The $28,840 figure might be more than 4 percent of your remaining portfolio, depending on how the markets fluctuated during your first year of retirement. Don't worry about it -- you only need to calculate 4 percent once. The guideline says you should withdraw 4 percent during your first year of retirement, and continue withdrawing the same amount, adjusted for inflation, each year thereafter.
Read More: Why the Rich Should Budget, Too.
What's the Difference?
The Multiply by 25 Rule estimates how much you'll need in retirement. The 4 Percent Rule estimates how much you should withdraw after you're retired.
Are Those Rules Accurate?
Some experts criticize these rules as being too risky. It's unrealistic to expect long-term annualized 7 percent returns, they say, for a retiree who keeps most of their portfolio in bonds and cash.
People who want a more conservative approach opt for a Multiply by 33 Rule and a 3 Percent Rule.Multiply by 33 assumes you'll have a "real" return - after inflation - of 3 percent. That represents a 6 percent long-term annualized gain, minus 3 percent inflation.
The 3 Percent Rule advocates withdrawing 3 percent of your portfolio during your first year of retirement. A person with a portfolio of $700,000 would withdraw $21,000 during the first year of retirement, adjusting for inflation to $21,630 the second year.
Some dismiss this approach as too conservative, but others argue that it's appropriate for today's retirees, who are living longer and want manageable levels of risk in their portfolio.