Discover how well you're prepared for retirement with the 4% rule

Golden eggs in a nest

Whether you're planning to retire next year or 25 years from now, you need to put the 4% rule to work.

It's one of the best ways to tell how much monthly income you can generate from a $50,000, $100,000 or $500,000 nest egg without having to worry about outliving your savings.

This time-tested guideline says you start by taking out 4% of your savings in the first year of retirement and then the same amount, adjusted for inflation, each year after that.

Let's say you have a total of $500,000 in stocks, bonds and CDs when you stop working.

That establishes a base for your withdrawals of $20,000 for your first year of retirement to cover your living expenses.

If inflation ran a typical 3% each of the next two years, you'd withdraw $20,600 in the second year and $21,218 in the third year.

Your balance will fall as you do that, even if you continue to earn a steady return on your portfolio.

But retirees who have followed the 4% rule have typically seen their savings last about 30 years.

You can't really know how well you're prepared for retirement without knowing how much income your savings can provide and using that to calculate your total replacement income.

That's the percentage of your current income you'll be able to replace once you've left the workforce.

For a comfortable retirement, your goal should be to replace at least 60%, and preferably 80%, of your preretirement income.

Most of us won't have to generate all of that money from our savings. We'll have Social Security and, if we're lucky, perhaps a traditional pension or two to help.

So, let's say you and your spouse make $70,000 a year, or about $5,800 a month, and want to generate 70% of your current income after you retire.

That works out to about $4,100 a month. (Replacement income calculations are almost always done on a monthly basis.)

The Social Security Administration can provide an online estimate of what your monthly benefits will be based on current law.

For this example, let's assume you will receive the average Social Security retirement benefit of $1,177 (as of the beginning of 2011).

That would provide a total of $2,354 per month and get you and your spouse more than halfway to your goal.

If you don't have any other sources of income to depend on, you'd need to generate the remaining $1,746 a month from your savings.

Using the 4% rule, that means you'd need $523,800 in savings to safely draw that much each month.

(Here's how to do the math: Multiply the monthly income you need from your savings by 12 and divide the product by 0.04. So $1,746 a month times 12 is $20,952; divided by 0.04, it's $523,800.)

Now you can use our Savings Goal Calculator or 401(k) Calculator to figure out what you must do to save that much.

Don't be discouraged if those calculators say you'd need to set aside more from your paycheck than you can possibly afford.

Save what you can. Retirement savings isn't an all-or-nothing proposition.

If you build a nest egg of $300,000, that's still enough to generate $1,000 a month in retirement income using the 4% rule.

Going back to our example, it would allow you to make up almost 60% of your preretirement income -- the minimum goal most financial advisers recommend.

We know that saving even $300,000 is a tough task for many families.

Only one in five workers age 55 and over reported retirement savings of $250,000 or more in the 2011 Retirement Confidence Survey from the Employee Benefit Research Institute (EBRI).

Just remember two of our 10 secrets to successfully save for retirement.

Take advantage of your employer's 401(k) plan.

It allows your retirement savings to grow tax-free, and it's virtually impossible to reach any goal if you don't take full advantage of that.

This is one of the two biggest tax breaks the government offers middle-income Americans, right up there with the mortgage interest deduction.

Many employers also match all or part of your contributions, another big boost you simply can't ignore.

The match is essentially free money, so you should contribute at least enough to maximize that match.

Our 7 rules for a successful 401(k) can help you make all of the right decisions about your retirement plan.

If you don't work somewhere that offers a 401(k) plan, head for a mutual fund company, stockbroker or even your local bank to open an Individual Retirement Account.

Whether you choose a traditional or Roth IRA, the advantage is the same as for a 401(k) -- your earnings can grow tax-free.

In 2011, you can contribute up to $5,000 per year (or $6,000 if you're 50 or older) to a traditional or Roth IRA.

Many savers can contribute to a 401(k) and IRA in the same year. Check with the person you choose to manage your IRA.

Just use the 4% rule as your benchmark for how much retirement income your savings can generate.

You can follow Interest.com on Twitter and Facebook.