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7 Best IRA Accounts to Open in 2021

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Opening an IRA account is an important step towards saving for retirement. The best IRA accounts have low fees, a wide array of investment options and tools that make investing easy. 

7 Best IRA Accounts to Open in 2021
Table Of Contents

Summary of Best IRA Accounts

M1 Finance

Best all around IRA Account

M1 Finance earns our top award for the best all around IRA account. It earns this honor for several reasons. 

First, it charges no account fees or transaction fees. Second, it enables you to build what it calls pies. You can think of a pie as a portfolio that you can include just about any ETF or stock that you want.

You can use pre-constructed pies that are excellent for retirement investing. In fact, I’ve created a 3-fund retirement portfolio in M1 Finance that anyone can use. I’ve also created several more complex portfolios to consider. 

With M1 Finance, managing an IRA is easy. You can rebalance a portfolio with the click of a button. And for those that want to invest in individual stocks, you can easily create a pie that contains the stocks of your choice or add individual stocks to a pie that is invested also in index ETFs like the portfolios above.

Account Types: Traditional IRA, Roth IRA and SEP IRA

Account Fees: $0

Transaction Costs: $0

Minimum Deposit: $100

Investing Tools: Easily create customized portfolios or use portfolios created by M1 Finance, auto-invest settings, auto-rebalance portfolio

Promotions: $30 bonus when you fund your account with $1,000+

Betterment

Best for hands-off investors

I met the founder of Betterment, Jon Stein, about 10 years ago. Since then, I’ve followed Betterment closely. It is one of two robo advisors I recommend for IRA accounts. 

7 Best IRA Accounts to Open in 2021

With Betterment, the only decision you have to make is how much you want invested in stocks and how much in bonds. Betterment even helps you make that decision through a series of questions. Once you set your stock and bond allocation, Betterment does the rest. It automatically allocates your portfolio across about a dozen stock and bond ETFs.

One downside of Betterment is that, like all robo advisors, there is a fee. Betterment’s fee is 25 basis points (0.25%) for what it calls Digital Investing. The cost goes up to 40 basis points (0.40%) with Premium Investing, which gives you unlimited calls and emails to Betterment’s team of Certified Financial Planners. These fees are in addition to the costs of the underlying ETFs. 

Pros:

  • Well established robo advisor
  • Reasonable costs 
  • Excellent portfolio construction 
  • Very easy to use
  • Human advisors for an extra fee

Cons:

  • Fees over and above the cost of ETS
  • Limited choices in portfolio construction

Account Types: Traditional IRA, Roth IRA, SEP IRA, Inherited IRA

Account Fees: 0.25% to 0.40%

Transaction Costs: None

Required Minimum: None

Investing Tools: Automatic portfolio construction, diversification, rebalancing, and dividend reinvestment

Promotions: Up to 1 year of waived account fees

Wealthfront

Best for hands-off investors

Wealthfront is the second robo advisor to make our list of the top IRA account options. It’s very similar to Betterment. You simply select your stock and bond allocation and Wealthfront takes care of the rest. 

7 Best IRA Accounts to Open in 2021

It has a similar cost structure at 25 basis points plus the cost of the underlying ETFs. It does have a few differences in terms of portfolio construction. Most notably it includes a REIT index fund in retirement accounts, whereas Betterment does not. Wealthfront automates investing. It helps you create a personalized portfolio, and then rebalances it automatically as markets fluctuate. 

Pros:

  • Easy to use
  • Low cost
  • Excellent portfolio construction
  • Automatically rebalances portfolio
  • Automatically harvests tax losses in taxable account

Cons: 

  • It does charge a fee over and above the ETFs
  • Limited portfolio construction options

Account Types: Traditional IRA, Roth IRA, SEP IRA and IRA Rollover

Account Fees: 0.25%

Transaction Costs: None

Required Minimum: $500

Investing Tools: Personalized portfolio construction, automatic rebalancing, automatic tax loss harvesting

Promotions: Get the first $5,000 managed for free (See details here)

Vanguard

Best for hands-on or hands-off investors

I’ve been a Vanguard client for decades. I’m a huge fan of their mutual funds and ETFs. Of course, you don’t need to open a Vanguard account to invest in their funds. In fact, you can invest in Vanguard funds through any of the IRA brokers listed here.

7 Best IRA Accounts to Open in 2021

For those who know they want to invest in only Vanguard funds, however, it is a good option for opening an IRA. It’s also a good option if you want to use its advisory services. It offers both a digital advisory service for 25 basis points ($3,000 minimum) and a human based advisory service for 30 basis points (minimum $50,000). Otherwise you can invest on your own for just the cost of the Vanguard mutual funds and ETFs.

Pros:

  • Excellent mutual funds and ETFs
  • Digital and human powered advisory services

Cons:

  • Website could be better
  • Advisory services have minimum investments
  • Vanguard mutual funds have minimum investments (typically $1,000 or $3,000)

Account Types: Traditional IRA, Roth IRA, SEP IRA, IRA Rollover, Inherited IRA

Account Fees: None unless an advisory service is used

Transaction Costs: $0

Required Minimum: $1,000 to $3,000 for many of Vanguard’s mutual funds, no minimum for ETFs, $3,000 for its Digital Advisory Services, $50,000 for its Personal Advisory Services.

Investing Tools: Asset allocation tool, investment comparison, screen & analyze investments, retirement planning tools, education savings tools.

Promotions: None

Fidelity

Best for hands-on and hands-off investors

Fidelity is a full service broker that powers many of the 401k plans and other retirement accounts. As an IRA provider, it gives investors access to virtually every mutual fund and ETF or stock available in the market. It does so without account fees, and its minimums, if any, are low. It offers excellent tools although frankly, in my experience, the website is not always the easiest to use.

7 Best IRA Accounts to Open in 2021

Fidelity also offers its own version of a robo advisor, called Fidelity Go. Unlike Vanguard’s Digital Advisory Service, it requires no account minimum and is free for accounts up to $10,000. For accounts between $10,000 and $49,999, it costs $3 a month. For accounts $50,000 and up it costs 0.35% per year.

Pros:

  • Wide range of investment options 
  • Robust investing tools
  • Low costs 
  • Fidelity Go

Cons:

  • Website can be difficult to use

Account Types: Traditional IRA, Roth IRA, SEP IRA, IRA Rollover, Inherited IRA

Account Fees: None

Transaction Costs: None

Required Minimum: None

Investing Tools: Stock ETF or mutual fund research and market analysis tools

Promotions: None

Merrill Edge

Best for hands-on investors and Bank of America clients

I recently opened a rollover IRA at Merrill Edge. It’s part of Bank of America, making it ideal if you bank at BofA. Merrill Edge can be a great way to have all of your accounts under one umbrella. Similar to a Fidelity or Vanguard, you can invest in just about anything through Merrill Edge. 

7 Best IRA Accounts to Open in 2021

It also offers a robust set of tools for research and analyzing investments, including tracking your progress towards retirement. It does offer its version of a robo advisor, called Merrill Guided Investing. The downside is that it’s more expensive than Betterment or Wealthfront.

Pros:

  • Low Cost 
  • Excellent investment tools
  • Integrated with Bank of America accounts 

Cons:

  • No automated rebalancing
  • Merrill Guided Investing more expensive that other robo advisors

Account Types: Traditional IRA, Roth IRA, SEP IRA, IRA Rollover, Inherited IRA

Account Fees: None for self-directed IRA accounts. Merrill Guided Investing costs 0.45% for online only and 0.85% for online with an advisor

Transaction Costs: None

Required Minimum: None for self-directed IRA; $1,000 for Merrill Guided Investing; $20,000 for Merrill Guided Investing with an advisor

Investing Tools: Research and retirement planning tools

Promotions: Up to $2,500 for new accounts depending on value. This promotion occurs annually for a limited time.

Ally Invest

Best for hands-off investors

Ally, the financial institution best known for online banking, brings the same excellent website and mobile app to an investment platform. It offers both self-directed IRAs and its own version of a robo advisor called Managed Portfolios. It also comes with a host of tools to analyze your investments and your portfolio. 

7 Best IRA Accounts to Open in 2021
7 Best IRA Accounts to Open in 2021

For self-directed IRAs, there are no commissions or account fees. The Managed Portfolios option requires just a $100 minimum. Unlike other robo advisors, Ally doesn’t charge a fee. However, it does require you to keep 30% of your portfolio in cash, which is a non-starter for retirement investing. As such, I don’t recommend Ally Invest’s Managed Portfolios unless you have a specific reason for keeping so much in cash.

Pros:

  • Virtually free 
  • Easy website to navigate 
  • Excellent tools
  • Excellent mobile app

Cons: 

  • Managed Portfolios keep 30% in cash 

Account Types: Traditional, Roth IRA and Rollover IRA

Account Fees: None

Transaction Costs: None

Required Minimum: None to open a self-directed account, $2,000 for margin accounts, and $100 for a Managed Portfolio account.

Investing Tools: Streaming charts, profit/loss calculator, market and company snapshots, probability calculator, watchlists, market data and option chains.

Promotions: $50 to $3,500, requiring a deposit of transfer of $10,000 to $2 million or more. Ally Invest also credits transfer fees, up to $150, when moving accounts from another broker.

How to Choose the Best IRA Account

Don’t focus on what you will invest in

One of the big misconceptions about opening an IRA account is that you should focus on what you want to invest in. When I started investing 30 years ago, this was an important consideration. I couldn’t go to Fidelity and buy Vanguard funds. Over time, you could but there were fees.

Today, you can invest in virtually anything  at just about any broker with few if any transaction costs. As a result, when opening an IRA account, the focus shouldn’t be on what you want to invest in. Instead, focus on how you want to invest.

Focus on how you will invest

There are basically three types of investors. There’s the hands off investors, who simply wants to set it and forget it. There’s the hands-on investor who wants to control every detail of the portfolio. And then there are those who want to be able to control their investments to some degree, but at the same time automate things like rebalancing the portfolio.

Understanding the type of investor you are will help you pick the best IRA account.

3 Types of Investors

1. Hands-Off Investors

The best IRA account options for hands-off investors are M1 Finance, Betterment and Wealthfront. Strictly speaking, Betterment and Wealthfront are the most hands off types of IRA accounts in our list. As noted above, you simply set the stock and bond allocation and they do the rest. The downside is that they both charge fees for the service of 25 to 40 basis points. While that may not seem like much, over a lifetime of investing it can easily add up to hundreds of thousands of dollars.

With M1 Finance, you do have to decide on the pie you want to use. They’re easy to create and there are pre-built pies that are ideal for long term retirement investors. Once you select one, it functions very similar to a robo advisor. 

Each contribution you make is divided among the individual investments in your pie according to the allocation you set. In addition, you can rebalance the portfolio with the click of a button. At the same time, however, you get great control over your investments. For example, if you wanted to add the stock of a single company to a three fund portfolio, you could do so in a matter of seconds. You could then allocate whatever percentage of that portfolio you want.

Either way, M1 Finance, Betterment and Wealthfront are all good options for hands-off investing.

2. Hands-On Investors

A traditional broker is certainly a strong option in our list that includes, Vanguard, Fidelity, Merrill Edge and Ally Invest. While they each have their own pros and cons, for most IRA investors it frankly doesn’t matter. You can buy any investment you want at any of these brokers and they all function in a relatively similar ways.

Alternatively, hands-on investors could use M1 Finance. As noted above, you can construct the pie or multiple pies as you see fit. You control the rebalancing and at the same time M1 Finance tools make rebalancing very easy.

3. Control with Automation

As you’ve probably guessed by now, there’s only one that fits into this category, and that’s M1 Finance. If I were starting as an investor today, I’d probably use M1 Finance. I use it today to invest all of the cashback credit card rewards that we receive.

Understanding the Impact of IRA Account Fees

Investment fees are critical to the long term performance of any portfolio. Most IRA account brokers charge no account fees or transaction fees. The one exception are robo advisors, including automated investing platforms at traditional brokers. Fees for these services range from about 0.25% to 0.45%.

It would be a mistake to dismiss these fees. While robo advisors are a good choice for those wanting totally hands-off investing, it’s important to understand how these fees can effect your wealth over time.  

Let’s assume you invest $500 a month over a 45 year period (we’ll ignore inflation). The account would grow to approximately $2.6 million with an 8% return (thank you, compounding!). If we reduce that return assumption by 25 basis points to account for the robo advisor fees, the account balance drops by more than $200,000 after 45 years.

While it’s certainly true that $200,000 45 years from now will be worth a lot less than it is today, it’s still a lot of money. This doesn’t rule out Betterment, Wealthfront or other managed portfolios. But it should be a consideration as you make your choice.

Mythodology

My analysis stems from holding accounts at each of the brokers on the list, with the exception of Ally Invest. I’ve had a Rollover IRA, Roth IRA, Traditional IRA, SEP IRA or an Inherited IRA at Wealthfront, Vanguard, Fidelity and Merrill Edge. I’ve held taxable accounts at Betterment and M1 Finance.

Beyond my own experience, I focus on fees and functionality. Fees are always critical, and how each broker works is important. You want to match your own personal approach to investing with the right IRA account. I also considered each broker’s website and mobile app, as well as their investing tools.

FAQs

Where is the best place to open an IRA?

For the vast majority of investors M1 Finance is an ideal option. It’s virtually free and gives access to just about every mutual fund, ETF or stock out there. In addition it has excellent tools to manage your portfolio, including automated rebalancing.

Are there any free IRA accounts? 

Yes. Most brokerage accounts today offer IRA accounts with no account fees and no transaction costs. One exception would be robo advisor type services, such as Betterment, Wealthfront or Vanguard’s Digital Advisory Services. These tools, while making investing easier, typically cost 25 to 45 basis points, in addition to the costs of the ETFs.

Can I open an IRA account if I have a 401k?

Yes. Having a workplace retirement account does not disqualify you from opening an IRA.
Your income, marital status, and other factors, however, could determine whether you can deduct traditional IRA contributions from your income, or whether you can contribute to a Roth IRA.

How the 4% Rule Works

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The 4% rule is a rule of thumb that can help you figure out how much money you can spend each year in retirement without going broke. If you’re many years away from retirement, you can also use it to figure out just how much money you’ll need to actually retire. This article is the first of a series exploring the 4% rule, how to apply, its limitations, and alternatives to retirement spending methodologies.

Table of contents

My Experience with the 4% Rule

The 4% rule hit home for me two years ago at the age of 51. I had just sold my business, an online media company that owned a number of finance blogs. And I retired. Yes, I’m part of the FIRE (Financial Independence, Retire Early) crowd.

At the time, I did all the calculations using the 4% rule on a very conservative basis. My wife and I had more than enough to retire. But actually doing it is a lot different than thinking and writing about it. After I sold the business, I was scared to spend the money. In fact, I was so scared, I took a full time job.

I know that doesn’t make a whole lot of sense. But that’s what I did. Now, in fairness, I worked at Forbes and enjoyed it immensely. It was lifestyle friendly. However much I enjoyed the work, it doesn’t change the fact that I built a business, sold it, and retired at the age of 51, only to go back to work out of fear of running out of money.

Now, the good news is it forced me to really take a deep dive into the 4% rule. I’ve read dozens of papers on the 4% rule. I have read books, I’ve studied dynamic spending plans, things called guardrails.

I’ve even looked at how institutional investors like the Yale endowment figure out how much money they can spend each year from the endowment without running out of money. There are a lot of parallels between how an endowment functions on the one hand, and how you and I should think about spending in retirement on the other.

What I learned from studying the 4% rule is that it’s a really good rule of thumb. It still works today. Second, almost no one should actually follow it in retirement. I know those seem to contradict each other, but they don’t, and I’ll explain why as we go along in this series.

In this article we’re going to look at four things. First, we cover a high level view of what the 4% rule is and how it works. Second, we’re going to look at who created the 4% rule. Third, we’ll cover how to use the 4% rule to estimate how much you need to save to retire. Finally, we’re going to look at some very bizarre results that can flow from actually following the 4% rule. So let’s get started.

How the 4% Rule Works

The 4% rule is simple to apply in retirement. It takes just 3 steps.

Step 1: Add up your retirement savings

The first step in using the 4% rule is to add up all of the money you’ve saved for retirement. This can include both retirement accounts as well as taxable accounts you expect to use to fund expenses in retirement. For example, you would include any money in a 401k or other workplace retirement plan, any IRAs that you have, and any money in taxable investing accounts, or savings accounts, certificates of deposit, or checking accounts.

Include anything you’ve saved, that’s going to be used to fund your retirement. Typical accounts include the following:

  • 401(k)
  • 403(b)
  • 457
  • TSP
  • IRA
  • Roth IRA
  • HSA (if used for retirement)
  • Taxable investment accounts
  • Savings accounts
  • Certificates of deposit

There are a few things you don’t include. You don’t include social security, annuity income or pension payments. You’re only factoring in money you’ve saved and accumulated for retirement. If you use a tool like Personal Capital to track your investments, this step is easy.

That’s step one. Let’s imagine that you’ve saved $1 million just to use a round number to make the math a little easier.

Step 2: Multiply your retirement savings by 4%

The second step is to multiply the results from step 1 by 4%. With $1 million, 4% would be $40,000. That’s the amount of money using the 4% rule that you could spend in the first year of retirement.

Step 3: Beginning in year 2 of retirement, adjust the prior year’s spending by the rate of inflation

It’s the second year that trips some folks up. The way you calculate all the years in retirement after year one is different. Beginning in year two, you do not use 4%. Instead, you take the amount of money you were able to spend the prior year and adjust it for inflation.

So in our hypothetical we spent $40,000 in year one of retirement. Let’s assume inflation is 2%. In year two, we could spend $40,800. To calculate this number, we simply add 2% to the amount we were able to spend in the previous year. Two percent of $40,000 is $800. Added to our first year spending brings us to $40,800. The following year we’ll increase $40,800 by the rate of inflation (or decrease it by the rate of deflation).

The 4% rule and the bucket strategy can lead to
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Where did the 4% Rule Come From?

The 4% rule dates back to 1994. It comes from an article published in the Journal of Financial Planning by William Bengen, a certified financial planner. He is the father of the 4% rule. The article–Determining Withdrawal Rates Using Historical Data.

Bengen’s primary focus wasn’t actually the 4% rule as we know it today. In fact, that term doesn’t appear in his paper. What he was more concerned with was how you go about calculating how much a retiree can safely withdraw each year from retirement accounts.

At that time, a lot of advisors would use average market returns and average inflation rates to determine the initial withdrawal rate. For example, they might explain to a client that a typical portfolio consisting of 60% stocks and 40% bonds has returned about 8% over the last 100 years. At the same time, inflation has averaged about 3% a year. Based on these averages, financial advisors would tell clients that they could withdraw 5% (8% average return – 3% average inflation) the first year of retirement, and then adjust that by the average rate of inflation. 3%

Bengen’s concern was that actual stock market returns and actual inflation rates might not support an initial 5% withdrawal rate. Even if the averages proved to be accurate over a 30-year retirement, really bad markets and high inflation in the early years of retirement could cause a retiree to run out of money before retirement ended.

And that’s in fact exactly what Bengen’s paper concluded. If you wanted to be completely safe, the most you could take in your one of retirement was 4%.

Now, we will look at the methodology behind the 4% rule and the assumptions he used in later articles. Both are extremely important to understanding how we can and cannot, and how we should and should not, apply the 4% rule.

How to use the 4% Rule for Retirement Planning

You can use the 4% rule to estimate how much you’ll need to save before you can retire.

Step 1: Estimate your yearly expenses in retirement

The first step is to estimate your yearly expenses in retirement. If you are near retirement, your current budget may suffice. Just remember to make adjustments if necessary to account for the transition from work (e.g., commuting costs go down, but retirement hobby or travel expenses may go up). If you are many years from retirement, taking a percentage of your current income (say 80%) may be sufficient for a rough estimate.

Step 2: Determine amount of yearly expenses covered by retirement savings

Next, estimate how much of your yearly expenses will be covered by retirement savings. For most people, social security and perhaps a part-time job will cover some portion of expenses in retirement. You can get an estimate of your social security benefits directly from the Social Security Administration.

Others may have a pension, an annuity or both. Subtract these other sources of income from your estimated yearly expenses. What is left is what must be covered by retirement savings.

Step 3: Multiply results from step 2 by 25

Multiply the results from Step 2 by 25. Note that this is the inverse of the 4% rule. If your expenses covered by retirement savings total $40,000 a year, multiplying this number by 25 gives us $1 million. Taking 4% of $1 million brings us back to $40,000.

How the 4% Rule can Lead to Bizarre Results

Now let’s underscore some of the difficulties with the 4% rule and why we need to be so careful with it.

Let’s imagine two couples are thinking about retiring. They’re good friends, and so the four of them go to a financial advisor together. The financial advisor explains the 4% rule–they can spend 4% of their portfolio in the first year of retirement and then adjusted for inflation every year thereafter.

One couple, we’ll call them the Retired Couple, decides to retire. They have a million dollar portfolio. They take out $40,000 in the first year, which leaves them with $960,000.

The second couple, will call them the Working Couple, decide to hold off for a year. They’re not going to add to their retirement portfolio, but plan to use the next year to pay off some debt before they retire. So they just leave the $1 million in their portfolio.

Now, let’s imagine that over the next year the market doesn’t do so well. Both portfolios fall by a total of 20%. So where do we stand after the first year?

  • Retired Couple: $1 million – $40,000 spending = $960,000 – 20% = $768,000
  • Working Couple: $1 million – $0 = $1 million – 20% = $800,000

Now let’s imagine the four of them go back to the advisor to find out how much they can spend in year two.

For the Retired Couple, they don’t look at their balance to determine how much they can spend in year two. Recall under the 4% rule that beginning in the second year, you simply take whatever you spent the previous year and adjust it for inflation. So if we assume a rate of inflation of 2%, the Retired Couple could spend $40,800 ($40,000 + ($40,000 * .02)).

In year two, the Working Couple who are now retiring for the first time, however, have to take whatever their balance is and multiply it by our familiar 4% number. Since they’re down to $800,000, 4% is $32,000.

Now if you think these results seem a little bit odd, it’s because they are. Our Retired Couple has a portfolio that’s lower than the Working Couple. They’re down to $768,000 compared to $800,000 for the Working Couple. Yet they can take out over $8,000 more–$40,800–compared to just $32,000 for the Working Couple. That seems like a pretty bizarre result to me.

Portfolio BalanceSpending AllowedCalculation Method
Retired Couple$768,000$40,800$40,000 + 2% inflation
Working Couple$800,000$32,000$800,000 * 4%

Now, what do we do with this? Does this mean the 4% rule is invalid? Does it mean it contradicts itself? Is it difficult to apply? Well, not exactly.

It does underscore the difference between theory and reality. And in fact, we’re going to cover a lot of realistic scenarios in this article series where the 4% rule, while it’s a good planning tool, and it’s a good rule of thumb, may not make a lot of sense when you go to actually apply it.

The good news is, I’ve got a number of alternatives that I’ll share with you that I think can be just as effective, but maybe a bit more practical to apply. So in the next article, we’re going to look at Bengen’s methodology–how he actually went about calculating what we now know is the 4% rule. Once we understand that we can begin to apply this information in a practical way to both retirement planning and retirement spending.

How the 4% Rule Works–Video

How the Bucket Strategy and 4% Rule Work Together

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Investing in retirement is scary for the most experienced investor. Combining the bucket strategy and 4% rule can help any retiree weather a bad market. Here’s how.

The Bucket Strategy and 4% Rule

I retired (the second time) at the age of 51. Having just sold my online business, my wife and I went from earning and saving money to living off of our investments. And even though we could live comfortably on about 2% of our nest egg, I was scared to death of running out of money.

It felt like I was on a life boat in the middle of the ocean rationing what little food we had left.

So a recent article in the WSJ—Investors Approaching Retirement Face Painful Decisions (paywall)—didn’t surprise me. According to the article, nearly a third of investors age 65 or older sold ALL of their stockholdings between February and May.

The news saddened me. Having spent years studying retirement investing and spending, I know that market timing is a recipe for retirement disaster.

Fortunately, a combination of the bucket strategy and the 4% Rule can save the day.

Table Of Contents

Retirees are Long-Term Investors

The WSJ article featured 62 year old Dr. Craig Sklar. COVID had caused a decline in his medical practice, forcing him to furlough staff and take on emergency loans. At the same time, his portfolio fell during the March Madness, as I like to call it.

So it’s understandable that he sold much of his stock investments. Understandable, but probably a mistake. He explained his decision saying, “I don’t have 10 to 15 years left to recover my losses.” Actually, he has more like 30.

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Retirees are long-term investors. If we assume Dr. Sklar lives to the age of 95, he still has 33 years left on this rock. That’s more than 3 decades of investing, long-term by any definition.

Of course, he will be spending some of his investments along the way. As he pointed out to the WSJ, “I’ll need my cash to live on.”

And that raises an important question—how does a retiree reconcile the current need for cash with the long-term need for market returns that only stocks can provide?

The Bucket Strategy and 4% Rule

The answer is a combination of two retirement money management frameworks—the Bucket Strategy and the 4% Rule.

The Bucket Strategy

The Bucket Strategy helps us divide our retirement money between short-term spending needs and long-term investment needs. In its simplest incarnation, we use just two buckets—Cash and Investments.

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Cash Bucket: This bucket holds three to five years worth of living expenses in cash (checking, savings, CDs, short-term bonds). Remember to deduct from your living expenses any other types of retirement income (e.g., pension, social security) before calculating your cash bucket needs. For example, if you need $75,000 a year before taxes, and social security provides $25,000, a 5-year cash bucket would hold $250,000 (($75,000 – $25,000) x 5 years).

Investment Bucket: Here we hold the remainder of our retirement funds in a diversified portfolio of low-cost index funds. The question we have to answer, however, is exactly what asset allocation to hold in this bucket. Is it 100% stocks? A 50/50 portfolio of stocks and bonds? Something else?

To answer these questions, we turn to the 4% Rule.

The 4% Rule

The 4% Rule arose from the work of financial advisor William Bengen. In a 1994 study, he found that a retiree could spend 4% of his nest egg in year one of retirement, adjust that amount by the rate of inflation each year, and not run out of money for at least 30 years (and in most cases, 50 years or more).

What doesn’t get as much attention is the asset allocation Bengen assumed in his study. His primary assumption was a portfolio of 50% stocks (tracking the S&P 500 index) and 50% intermediate term treasuries. Further, he assumed the retiree rebalanced the portfolio annually.

What they didn’t do was sell all their stocks in a bad market. And his study covered some really bad markets—1929 stock market crash, the final years in the 1930s, the stagflation of the 1970s. Through all of these difficult times, the 4% Rule survived.

Bengen did look at other asset allocations, ranging from 100% bonds to 100% stocks. What he found is that portfolios with a stock allocation between 50% and 75% lasted the longest. Add more stocks and the market volatility would hurt the unfortunate retirees who retired just before big market declines (particularly if inflation spiked). Hold less than 50% stocks and the returns were not sufficient to sustain a 30-year retirement in many cases.

So just like Goldilocks and The Three Bears, a 50% to 75% stock allocation is “just right.”

Putting it All Together

If we follow the 4% Rule, we want our overall portfolio to consist of 50% to 75% stocks. Here we combine both of our buckets (cash and investments) to determine our overall asset allocation. There are several ways to track our asset allocation across all our accounts.

The most effective tool and the one I use is Personal Capital. It’s free and it enables you to link all of your investment accounts (retirement and taxable) as well as all of your cash accounts. Once linked, you can see your asset allocation with a click of the mouse.

It’s here that the Bucket Strategy and the 4% Rule work together. The Bucket Strategy serves two critical roles. First, of course, it assures we have the cash we need for everyday expenses. Second, by having a cash bucket of three to five years, we are better positioned to handle the fear of market declines in our investment bucket.

This second objective cannot be overstated. Fear is what often drives any investor to sell during sudden market drops. It’s exactly what more than 100 years of data and experience tell us we shouldn’t do. If five years of living expenses in cash isn’t enough to calm your fears, than make it six or seven.

As you make these decisions, be sure to keep an eye on your overall asset allocation. So long as your stocks don’t drop below 50% of your portfolio, you’re still following the 4% Rule as envisioned by Bengen.

How Retirees Can Survive a Bear Market [Video]

New to investing and managing your money? Check out my book,
Retire Before Mom and Dad.

“This book is a must-have for anyone, regardless of age, to understand how to grow and protect our money over the course of our lives.” — Adrienne

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