Living off investments defines financial independence. Just how much money do you need to live off investments completely?
Get a good estimate by dividing your annual desired income by the expected yield. For example, if you want $10,000 a month in investment income, divide $120,000 ($10,000 x 12 months) by the yield (5% in this example) to get the amount of money you’ll need to live off investment income, or $2,400,000.
This is the simple formula to show how much money it will take for you to live off investment income only. In other words, you want to live off the income your investments generate without spending your investment capital. This is the best way to live off investments, so you don’t have to deplete your investment capital.
After investing for almost 40 years and living off diversified income streams over the past 15 years, I’ll share what I’ve learned about estimating how much money you need to live off investments, and what all you’ll want to consider beforehand.
More Than Investment Income
For most people estimating how much money they’ll need to live off investments, it can be more complex than the investment income formula above. This is because investment income alone doesn’t generate enough money to live for most people, so capital gains and maybe even invested capital are needed to live, in addition to just investment income.
It’s very important to understand these differences in determining how much money you need if you’re planning to live off investments at any time in the future.
In this post, I’ll explain the difference between those three potential levels for living off investments so you can see what your options are, and how you might go about estimating the amount of money you need.
Living Off Stocks and Bonds Only
I’ll focus mostly on living only off investments in stocks and bonds since most people think of only this as their investments.
Note that, however, there are a lot of ways you can live off investments when you consider real estate and small business investments in addition to stocks, bonds and slightly alternative investments such as MLPs and REITs.
And let’s also disregard other potential income sources, such as social security in this post, especially since you may be younger than retirement age, as we were when we began living off alternative income sources including investments.
Using Account Size and Yield to Determine How Much Money You Need
First, you’re faced with the decision of whether to live off income from investments only, as in the example above, or spending investment capital to live. Whether or not this is even an option depends on how much money you have, and how much yield you’ll earn on investments, so let’s start there.
For example, if you have $1,000,000 earning 5% from dividend stocks, this will generate $50,000 income a year (before considering taxes).
If you have $500,000 earning 5% in dividends, the income will be $25,000 a year.
To be honest, a 5% income yield from traditional stocks and bond portfolios is optimistic these days, as I’ll explain more later in this post.
This simple math is very telling. This is because in this example, we’re focusing on investment income only vs capital gains.
But most people who live off investments don’t just rely on investment income for several reasons, as I’ll explain next in more detail.
Envision Layers of Money in Retirement Accounts
Even though it seems like your money is all lumped together in your investment accounts, think of your investment or retirement accounts in this way to differentiate truly living off investments vs withdrawing your investment capital. Envision 3 Wealth Layers in your investment accounts, much like in the delicious looking cake you see above.
Wealth Layer 1 – Investment Income Only
At the top layer of your investment accounts, you have dividend or other income, such as bond interest. Spending from here is literally living off investments since you’re using flat out income that your investments generate for you.
Think of this as the very top layer of that cake, that top layer of chocolate. That top layer of icing is usually thinner than the other layers, but we all know it’s the richest part.
Much like the chocolate, layer 1 is the most desirable way to live off investments. This is because you can leave both your entire capital gains and initial savings deposits in the account to continue to compound wealth.
The drawback is that living off investments with this method requires a high amount of money in your investment accounts, a high yield, or both to generate enough money to live.
Investment Yield and Account Size
As you can see from these examples, the amount of money, the types of investments you have and the yield they earn determine how much money you need to live off your investments without running out of money eventually. But if you can live off Level 1, you don’t even have to touch your savings. This is a beautiful thing.
In the examples below let’s vary the investment income yield and the amount of money in the investments to demonstrate this point better and plant the seed for optimism.
You saw the examples above with 5% from dividend income on $1,000,000, or $50,000 a year, but let’s expand on this formula in more alternative investments.
Higher Investment Yield Examples
For an investor with $1 million in higher yielding stocks and “slightly” alternative investments such as preferred stocks, MLP’s and REIT’s earning a 7% yield, annual income would be $70,000 a year. Yes, these assets would swing in value, but so do all stocks and most bonds.
An investor with a million in real estate rentals yielding 10% on invested capital may make $100,000 a year from investment income.
A stock investor who sells covered calls may make 12% a year on $1 million invested in stocks earning $120,000 a year.
♦ Income Stream Tip: Caution – Basic covered call strategies work best during sideways or rising markets.
Again, the amount of investment income is a function of investment yield and the amount of money you have invested in income generating assets.
Note that for most traditional, passive stock and bond investors going for a slightly higher than market yield on a diversified portfolio, it’s about 4% these days, if that much.
The good thing is that while the amount of money invested, and the yield being earned, is not always completely under your control, it is certainly under your influence by being proactive as an investor.
Layer 2 – Investment Income Plus Capital Gains
At the next layer down, you withdraw at least some capital gains from investments. You’ll need to understand how this works in order to determine if you want to rely on capital gains (in addition to income) to get a good estimate of how much money you need to live off investments.
Referring to our layer cake example, Level 2 is that yummy creamy center. It’s not the foundation layer (your savings), but it’s not exactly the income layer either. Level 2 has your capital gains in it, and you’ll want to decide if you’re comfortable spending at this layer.
Most people living off investments spend all the money from the top, or income layer first. Then they dip into Layer 2.
The longer you’ve been investing in increasing assets, the bigger layer 2 will be, as you’ll see below.
Remember that capital gains are the amount that your investments have increased in value since you bought them. For example, if you buy an investment at $100 a share and the value increases to $150 a share, you have a $50 capital gain.
Example of Living Off Income and Capital Gains
Below is an example of living off both income and at least some capital gains.
Let’s say you make $5,000 a month from stock dividends in your account. This is your usual monthly spending from your investments.
Every year you take a nice trip. One month, you decide to take a trip to Europe with your family. Like me, you’re flying with free miles and staying at some amazing inexpensive smaller inns and vineyards, so the trip cost is just $10,000.
But you only have the $5,000 investment income which is already applied toward your usual monthly expenses. You look at your investments and see that you have some Apple stock which has increased in value over the years from your initial cost of $10,000 to a current value of $20,000. You decide to sell $20,000 worth of Apple stock.
As a result, you have a $10,000 capital gain in this example. You’ll use this money to fund your trip. In addition, you used $5,000 to pay the usual bills that month.
Your total expenses of $15,000 that month came from both investment income and the Apple stock capital gain.
Using our cake analogy, you ate the chocolate on the top layer, and then you dipped into the creamy bit that month to fund your trip to Europe. (Sounds delicious!)
Consistent Investment Income
At this point, you may be wondering about the typical retirement withdrawal rules you’re read about where you get consistent amounts each month that can and do often exceed Layer 1, or investment income.
This is method is very common in traditional retirement planning (in addition to annuities) so I’ll address it here since the method you choose to live off investments will affect the amount of money you’ll need.
4% Retirement Withdrawal Method
A consistent withdrawal method that is typically associated with retirement is the 4% rule. This method has been very common since the 1990’s for someone living off investments, also known as retirement.
With this method, a retiree withdraws 4% from their investment account each year to live. This is nice because the money is steady, whereas dividend and interest income can vary from month to month since many dividends pay quarterly.
2% Retirement Withdrawal
After the two bear markets during the 2000’s decade, the 4% withdrawal rule was revisited. New research showed that a retiree withdrawing 4% could run out of money.
As a result, withdrawals of 2% to 3% were suggested. (This demonstrates that the safe withdrawal amount varies based on market trends during the time just before and after retirement.)
Note that withdrawals may come from Layer 1, 2 or 3 based on how your investments have performed since you retired, the investment yield and how much money you have.
Again, for a very wealth investor, enough income may be generated to provide the entire withdrawal.
No Capital Gains
Regardless of the method used to live in retirement, there could be periods during occasional bear markets when the retiree has no capital gains in the account and must sell investments at a loss. This is when living off investments at Layer 2 gets tricky.
The other factor here is time. How often stocks are bought and sold in the account will affect whether or not capital gains exist.
Investment Cash Layers
One more note about capital gains is that during the times when there are no securities to sell at a capital gain, a retiree can turn to their cash (money market) to live. This is why it is so important to have a portion of your net worth in cash type investments that don’t fluctuate in value due to market cycles.
As stocks become overvalued during bull markets, it can even make sense to raise cash layers. This is counter intuitive since stocks are soaring, but it naturally reduces investment risk and provides a bigger cash cushion during bear markets.
Low Interest Means Low Income from Cash
One problem is that investment “cash” would most likely be in a money market fund which earns a low interest rate, often below inflation, giving investors a negative real return. That interest rate will vary depending on what the economy and the Federal Reserve do.
As of this writing, interest rates are still near historical lows, making it difficult to earn much money off money market funds. This has led many investors to invest in stocks at a higher layer than normal just to try to make more money.
If you plan to live off investments, you can see the importance of having enough money in cash (money market) for those periods when investments decrease in value.
Of course, for someone with a significant amount of money in investment accounts, when there is no real concern of running out of money, it could make sense to have lower layers of cash since selling securities at a loss (during occasional bear markets) is not a big threat to their lifestyle.
Bonds Vs Cash for Investment Funds
Note that a typical diversified portfolio would include bonds. Often bonds increase in value when stocks decrease in value.
Selling bond investments would be another alternative to provide funds during bear markets for those living off investments. While bond income has been minimal for years, there may be capital gains in bond funds during times when they don’t exist in stocks.
Taxes Can Be a Forgotten Living Expense
Remember that when an investment is sold, as in the above example of Apple stock, you may have to pay taxes on the profit. Also, investment income can be subject to taxes.
For this reason, it’s important to set aside money for taxes, or make quarterly tax payments when appropriate. (You can check with your CPA.)
It will be important to consider taxes when figuring out how much money you’ll need to live off investments since it is often an often an individual’s largest expense.
Layer 3 – Income, Capital Gains Plus Savings
Spending at the next, and last layer down includes spending your investment capital, or savings, in addition to spending income and capital gains. Here, you’re spending that hard earned money, bonus or inheritance money that you made certain to put into your investment accounts.
In other words, referring to our delicious layer cake, you’re eating the chocolate icing layer at the top, the creamy bit in the middle and at least some of the bottom layer of cake, too.
As you can see, ideally you won’t have to spend at this layer, at least not early in retirement. It’s best to save that foundation layer for later in life if your numbers indicate any chance of running out of money.
Problems with Living Off Investments
Most plans for living off investments are based on skimming off that top layer of income and capital gains and providing you money to live, or Layer 2. This is ideal when it works, and for those with high layers of wealth.
But there can be several problems you’ll want to know about so you can plan the amount of money you need with more accuracy.
Stock Index Fund Investments
For one, masses of investors are invested in index funds which have a dividend yield of under 2% as of this writing. This means that there is little income.
Of course, this problem can be solved since you can always shift to higher yielding dividend stocks or funds. Hopefully, this can be done without incurring taxes on the switch.
But even so, with all the demand for higher yielding stock funds, the yield is still under or around 4% or 5% for most dividend focused stock funds.
Covered Calls Increase Stock Income
Note that some proactive investors, financial advisors and funds sell covered calls since it increases the amount of outright income from stocks even though it sometimes limits capital gains. Selling out of the money covered calls on long time stock holdings in tax deferred or tax free accounts can provide a good source of mostly passive income without the risk of triggering capital gains on long term stock holdings.
Doing so can make that top income layer over twice as thick. If you’re invested in stocks anyway, covered calls can make sense for many investors.
Another concern with living off investments, as explained above, is that since some retirement years won’t have capital gains due to stocks (or bonds) being up some years and down other years, living off investments can be problematic at times. This makes the income level, Level 1, all the more important.
How You Feel About Living off Investments from Income Vs Capital Gains Vs Savings
While all the money (dividends, capital gains and capital) is lumped together in your account, when you think of living off investments in different layers, you can first see if you can live off investment income only.
This allows you to feel like you aren’t spending your hard earned money every time you pay bills since you’re truly not. Otherwise, spending from your investment accounts can feel very scary and unpleasant.
Your money is working for you, and paying you income, especially at Layer 1. Again, the formula to calculate how much money you need to live off investments at Level 1 is simple as you saw earlier.
At the next layer down, Layer 2, which includes capital gains, your money has also worked for you to make more money. For most people, spending at this layer is not quite as comfortable as spending from the income layer except for those with very high net worth.
Spending both income and capital gains, Level 2, can, however, still be an excellent strategy when the numbers work.
You can use a retirement withdrawal calculator to determine how much money you need to live off investments with this method but realize that the results are truly only an estimate since most of the inputs (such as future returns) are estimates.
At the next spending layer, Layer 3, you’re spending your hard earned money, which is your capital. It’s your savings.
Spending savings feels scary for most people except those with very high net worth. At this level, you’ll want to make sure you have enough money to fund living expenses for your estimated life expectancy.
Influencing Your Retirement Account Layers
The good thing is that you can increase the layers in your retirement accounts, especially the income layer, to affect if and how you can live off your investments.
The middle layer takes many years to increase, or perhaps successful proactive investing to increase it in shorter time frames. And the bottom layer is simply what you’ve chosen to save over the years.
It, too, can increase significantly, however, with proactive investing or lifestyle changes, such as downsizing.
Click here to watch my video Wealth Building After 50.
Opportunities to Live Off Investments
You may feel discouraged that you’ll never be able to live if your investments. I understand, as I’ve been there, but you can almost always control your ability to live off your investments.
As a society, we have been influenced to believe it is someone else’s responsibility, such as the government, your financial advisory, or employer, to be able to live off investments one day, which is simply retirement. This culture is leftover from the previous generation when corporations or the government often did provide more retirement funding.
Now it is my responsibility, and your responsibility to be able to live once the steady paycheck ends. With this acceptance comes a plethora of options, available information and alternative investments to live off investments easier than ever before in history.
All this has created wonderful opportunities to be able to be able to fund your living expenses and build wealth where they simply didn’t exist for earlier generations. Just a few decades ago, there was only your employer controlled retirement account, maybe a stock broker, and old news from paper publications.
Now, you can have state of the art investment research within a few seconds delivered by your choice of text, audio or video. You can learn how to invest in anything, including how to invest in real estate rentals, sell covered calls or find high yielding stocks within an afternoon.
Add in the fact that you can reach a global market with an online presence for less than $100 for retirees interested in creating a small online business.
With this information comes the power to control your financial existence. The opportunities are here for anyone who wants to take them. Choose one or two that align with your skills, resources and lifestyle and go for it.
Living Expenses Are the Foundation for Living Off Investments
Speaking of lifestyle, the amount of money you need to live off investments in the first place is a function of your lifestyle spending. This is why it makes sense to first clarify the lifestyle you really want, and how much money you’ll need to fund it, before you do any of the math.
This is where I like to start with my financial coaching clients because sometimes, the life we really want costs much less than we thought, and sometimes more. It’s all about priorities.
After considering the layer at which you’re comfortable spending, and playing with your numbers, you’ll have a better perspective for how much money you’ll need to live off your investments at the layer you choose.
Only after you have gotten clear about the cost of life you want can you determine how much money you need to live off your investments so can fund that lifestyle in a way that is comfortable for you. This is true financial independence.
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