If you’re exploring early retirement like we were well over a decade ago, you may be wondering about the income provided from the standard 4% retirement withdrawal rule.
Does the 4% rule include dividends, specifically? The 4% rule can include dividends if they exist in the account since the rule is more about the amount being withdrawn than the source. The 4% rule withdrawal may be derived from deposits, capital gains, dividends, interest, or compounding. A retiree may, however, choose to invest in dividend stocks to provide withdrawal funds for part or all of the 4% being withdrawn.
There are important considerations for the 4% rule as well as dividends as part of the amount being withdrawn when using the 4% rule as you’ll see in this post.
While I’m an AFC (Accredited Financial Counselor), my experience as a multi decade personal investor and financial coach provides most of the information for this post.
Dividend stocks have been a popular investment for retirees in recent given the low yields that bonds provide.
Let’s explore the role dividends play in the 4% rule with more about the retirement withdrawals themselves.
How Do Retirement Withdrawals Work?
Retirement withdrawals are made annually for a set percentage that retirees believe will be sustainable for life.
The 4% rule was developed by William Bengen in 1994 as a reliable amount to withdraw in retirement without running out of money.
While 4% has been debated by financial advisors and wealth managers as a reliable withdrawal rate it is a good estimate and serves for the purpose of this post about how and if the 4% rule includes dividends.
Here’s how retirement withdrawals work: In the first year of retirement, 4% is withdrawn. The amount is increased annually for inflation in subsequent years to maintain purchasing power.
To explain the role dividends play in the 4% rule, it’s important to understand what makes up the account from which you’ll be making retirement withdrawals.
While it can feel like everything is all the same when you see a lump sum in your retirement account, the account wealth is made from five components, including dividends:
- Initial deposits into savings over the years
- Growth from investments (called capital gains)
- Compounding of reinvested dividends, interest, and capital gains
Some of these elements overlap. For example, as a part of compounding, dividends may be reinvested and result in more dividends and also capital gains. I like to think of all 5 as different elements, however, sort of like buckets of money that came about from different actions taken by an investor.
The 4% rule is the amount to withdraw, period. It is source agnostic and matters not how the money got into the account. The 4% rule is based on the math behind withdrawing retirement funds in retirement.
In other words, Bengen didn’t consider an investor might apply the 4% rule by withdrawing 4% from one retirement account and also generating 4% in dividends from another account and keeping those dividends instead of reinvesting them.
Dividends, however, can make a difference as to how long retirement money will last using the 4% rule so let’s take an example; just think if an investor did the above?
Dividends As Part of the 4% Withdrawal Rule
Let’s say you are withdrawing $36,000 based on the 4% rule in your first year in retirement. You have $9,000 in dividend income that is paid to you (not reinvested) for the year in the account from which you are making retirement withdrawals.
You could withdraw the dividend income of $9,000, and you’d also withdraw $27,000 that would need to come from your savings deposits, capital gains, or from compounding.
By actively generating either dividend income or capital gains that exceed the amount being withdrawn every year, proactive investors can affect how long their retirement savings will last as explained more in my article How Much Money Do You Need to Live Off Investments?
Higher Investment Income Can Help Retirement Account Longevity
As you can see from the example, the more dividends you get from your stock portfolio, the less you need to withdraw from your retirement savings deposits, capital gains, and compounding.
For this reason, an investor proactively focused on creating a diversified portfolio of high dividend stocks could have a significant impact on how long her money will last in retirement.
Importantly, high dividend stocks also have good capital gains potential while generating higher investment income.
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Dividends tend to be more predictable than capital gains, too, while assets can have capital losses instead of gains in some years as retirees in the first 2000’s decade learned the hard way with two horrific bear markets.
Ideally, retirees can withdraw from investment income that’s consistent and then dip into less consistent capital gains as needed while leaving deposits intact as long as possible.
Let’s look at an example with a portfolio that has high dividend stocks.
4% Rule with High Dividend Example
In the example above, the retiree had about a $900,000 retirement portfolio to back into the $36,000 withdrawal year one in retirement. Here’s the math:
4% Rule x $900,000 Retirement Savings = $36,000 Withdrawn Using 4% Rule
To address dividends in relation to the 4% rule, we’ll address only the stock portion of her portfolio since that is the topic of this post; note that most accounts will also have bond interest, albeit slight, which will increase retirement portfolio income, too.
Let’s assume Jill is using a typical asset allocation for her age and risk profile of 50% stocks and 40% bonds and 10% money market or portfolio cash. (My post How to Understand Your Investments explains this more if you want a refresher on asset allocation.)
The amount allocated to stocks, then, is $450,000. Here’s the math:
$900,000 Retirement Savings x 50% = $450,000
Assume the stock allocation was invested in stocks in the S&P 500 index yielding around 2%, as is common.
Jill wants to retire at 55 in one year and live off investments. While preparing for retirement beforehand, if she moved her stock portfolio to a diversified portfolio with stocks yielding 5%, her dividend income would increase to $22,500.
As a result, she would need to withdraw only an additional $13,500 from her nest egg built from retirement saving deposits, dividend income, bond interest and compounded wealth.
Watch my related video Which Retirement Withdrawal Strategy Works Best?
Remember, the withdrawal amount will be increased annually for inflation. Just imagine how much will need to be withdrawn after twenty to thirty years in retirement.
Inflation is a wild card, too, since it was as high as 13% in the early 1980’s! Retirees simply cannot be complacent about investing if they want their retirement accounts to last for life.
Retiree investment income or their investment returns must keep pace with inflation to reduce this stealthy risk.
Are High Dividend Stocks Safe in Retirement?
It’s easy to forget that all stocks are subject to stock market risk. Bear markets come along once or twice a decade.
The last two secular bear markets led to stocks dropping over 50%. Many earlier bear markets and those in the 2010’s decade were less severe and shorter.
When it comes to dividend stocks and bear markets, I like to plan to account for the worst and hope for the best. It’s important to note that almost all stocks drop during bear markets, including higher dividend stocks.
For this reason, it’s important to manage investment risk based on your own personal wealth plan which includes risk tolerance as explained more in my post How to Keep Your Wealth Safe.
Are Dividend Stocks Riskier Than Non Dividend Stocks?
Portfolio stability is important for retirees making annual withdrawals of 4% initially or any other amount.
It was noted previously that dividend income can provide more consistent investment income vs capital gains and high dividend stocks can increase income from which a retiree can withdraw.
Some stocks with higher yields tend to drop more during bear markets because they have more perceived risk, however. Other stocks drop less because they have a lower perceived risk while some stocks go up in bear markets.
“Riskier” stocks often have to pay higher dividends to attract investors. This associates higher risk with higher dividend stocks. This perceived higher risk is offset by the fact that income stocks generally drop less during bear markets because they offer investors income at a time when they are not getting capital gains from stocks.
Note that most stocks eventually get back to where they were before the bear market began and move higher (based on history) but seeing the value of retirement savings and net worth decline can be unnerving.
The good thing is that investors can own assets that are noncorrelated to their dividend stocks for managing risk. Risk management is especially important when making retirement withdrawals to live.
For example, usually, U.S. Treasury bonds go up when stocks go down during bear markets. Other defensive investments can also be considered by investors now that bonds have lost their luster given low interest rates, and, along with them, the end of their multi decade bull market as explained in my post on the risks of bonds.
Asset allocation among noncorrelated assets can be an excellent way to reduce investment risk for passive investors. I have written extensively about this in my post How Will a Stock Market Crash Affect Me?
My related video Is Dividend Investing Worth It? has more about the risks of dividend stocks.
4% Rule Dividend Summary
The 4% rule will likely include at least some dividends as part of the annual withdrawal for stock investors.
Every investor is different. Therefore, it’s important to expand beyond this simple answer with important information that can be used to reduce risk while building wealth before and during retirement.
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You can read more about the 4% Rule in my post Retirement Withdrawal Strategies: Do They Still Work?
How Much Should a 50 Year Old Have in Bonds?
How to Account for Inflation in Retirement Planning