Updated February 3, 2020
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 ideal 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.
There’s some super important risk related factors you don’t want to miss so be sure to read this entire post.
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.
When this is the case, capital gains and maybe even invested capital are needed to live, in addition to just investment income. These are all different layers of your wealth.
It’s very important to understand these layers 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 layers for living off investments so you can see what your options are and how you might go about being able to live off investments at the time you choose.
Living Off Stocks and Bonds Only
In this post, I’ll focus mostly on living off investments in stocks and bonds since these are the most common investments.
But as you’ll see, 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.
Let’s also disregard other potential income sources, such as social security in this post, especially since you may be younger than the common retirement age of 63, like we were when we began living off alternative income sources.
To go along with this post, I created a complete free Living Off Investments Guide here with video training to see how close you are.
Using Account Size and Yield to Determine How Much Money You Need
When you’re considering how to live off investments, first, you’re faced with the decision of whether to live off income from investments only, as in the example above, or spending your savings (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 3% from dividend stocks, this will generate $30,000 income a year (before considering taxes).
If you have $500,000 earning 3% in dividends, the income will be $15,000 a year.
A 3% income yield from traditional stocks and bond portfolios is realistic if not optimistic these days. It can be improved, however, 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 from your investments, or the increase in value.
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 investments or retirement accounts in layers to differentiate truly living off investments vs withdrawing your investment capital.
This is a very important concept that many investors get confused about so let’s use the example of a cake to demonstrate this point.
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’s made up of all 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 icing layer of cake, layer 1 is the most desirable way to live off investments. This is because you can leave both your entire capital gains and past savings deposits in the account to continue to compound wealth.
But much like getting a fork and scooping off that top layer of icing, there’s a drawback. The drawback is that living off investments from income only requires a very high amount of money in your investment accounts, a high yield, or both to generate enough money to live for most people.
Investment Yield and Account Size
As you can see from the two examples above for income from $1,000,000 and $500,000, 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 the icing, or 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 explore potential ways to live off investments with less savings.
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.
Note that these assets would swing in value, but so do all stocks and most bonds.
Here’s another example. Real estate is a little more complicated due to financing, expenses and tax benefits, but let’s take a simple example.
An investor with a million dollars in real estate rentals yielding 10% after expenses may make $100,000 a year in investment income.
Or a stock investor who sells covered calls may make 10% a year on $1 million invested in stocks earning $100,000 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 the yield on a diversified portfolio, it’s about 2% these days, if that much. And even most income focused stock funds only yield about 2% to 3% as of this writing.
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.
This means proactive investors can get higher yields making it easier to live off investments.
Now we’ve looked at the yummy income layer of your investment accounts. Let’s look at the next layer.
Layer 2 – Investment Income Plus Capital Gains
Let’s say that the income generated from your investments is not providing enough income to live so you need to get more money to pay the bills. This takes you to the next layer.
At the next layer down, you withdraw at least some capital gains from investments. And this can work fine for a lot of investors.
But 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 otherwise you may spend too much of this important layer of your savings.
Referring to our layer cake example, Level 2 is that yummy creamy center. It’s not the foundation layer (your savings deposits), 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 assets increasing in value, the bigger layer 2 will be, as you’ll see below. Over decades, for example, the value of stocks increase in value.
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 for $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 retirement savings account. And let’s assume 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. If you’re 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 at home 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 in layer two that month to fund your trip to Europe. (Sounds delicious!)
Read my article Wealth Building Vs Income for more on this.
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. Those withdrawals can and do often exceed Layer 1, or investment income.
This withdrawal method is very common in traditional retirement planning (in addition to annuities) so I’ll address it here because the ideal plan for retirees is to live off investments whether that’s from investment income or withdrawing retirement savings.
Take my Living Off Investments Challenge starting with the video below. Be sure to get the Living Off Investments PDF here so you can complete it as you watch.
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, of course, is time. How often stocks are bought and sold in the account will affect whether or not capital gains exist.
In other words, a long term buy and hold stock investor that has been in the market for decades will have capital gains. An investor that frequently buys and sells stock won’t.
Investment Cash Layers
A safety net for when there are no securities to sell at a capital gain is for a retiree to use cash (money market) to live. This is why it is so important to have a portion of net worth in cash type investments that don’t fluctuate in value due to market cycles especially when living off investments.
As stocks become overvalued during bull markets, it can even make sense to raise cash layers even though the returns are lower. This is counter intuitive since stocks are soaring, but it naturally reduces investment risk and provides a bigger cash cushion during bear markets.
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.
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 so bonds may potentially provide capital gains.
Now let’s look at Layer 3.
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 worked 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 to live off investments 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.
This problem can be solved by shifting to higher yielding dividend stocks or 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, selling covered calls can make sense for many investors since they can double to quadruple income from stocks while lowering risk.
The most popular plan for retirees to live off investments is with retirement withdrawals so let’s address that next.
Retirement Withdrawal Methods
It’s important to address retirement withdrawals because most retirement plans are based on using them. But, also, the success of retirement withdrawals providing funds for life depends on the 3 layers that this posts addresses so it’s super important to understand this if you don’t want to run out of money.
Withdrawals may come from Layer 1, 2 or 3 based on how your investments have performed since you retired, the investment yield you’re getting and how much money you have.
4% Retirement Withdrawal
A consistent withdrawal method that is typically associated with retirement is to withdraw 4%, adjusted for inflation, each year to live. This method has been very common since the 1990’s for someone living off investments, also known as “retirement” by most.
With this method, a retiree withdraws 4% from their investment account each year to live.
2% Retirement Withdrawal
It’s important to note that after the two bear markets during the 2000’s decade, the 4% withdrawal rule was revisited. New research showed that a retiree withdrawing 4% may run out of money if retirees ran into another troubling decade like the 2000s decade.
This is because Layer 2 was gone for many retirees! And layer 1 was affected for many investors since jobs were lost during those bear markets and recessions. (This will happen again.)
As a result, withdrawals of 2% to 3% were suggested instead of 4%.
This demonstrates that the safe withdrawal amount varies based on market trends during the time just before and after retirement, a core principle at Retire Certain.
Read my related post Predictors of Bear Markets for more on this OR..
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’ll want to 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 induce guilt.
But at Layer 1, your money is working for you, and paying you income.
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.
But spending both income and capital gains, Level 2, can, however, still be an excellent strategy when the numbers work.
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.
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 of capital gains takes many years to increase. Alternately, it can be done with successful proactive investing in shorter time frames. But there are many factors beyond your control in creating capital gains, such as the economy and stock market cycles.
And the bottom layer is simply what you’ve chosen to save over the years.
It, too, can increase significantly, however, by creating new skill based income streams, proactive investing or lifestyle changes, such as downsizing.
Click here to watch my related 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 mindset 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 for investors to build wealth.
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.
And thinking a little more outside the box, you can create an online business that reaches a global market for less than $100 where you can sell your skills or products.
With this information comes the power to control your financial existence. The opportunities are here for anyone who wants to take them.
If the living off investment formula in paragraph one doesn’t allow you to live off investments as soon as you want, do something about it. Choose one or two opportunities to build wealth and/or generate income 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 from the layer you choose.
This is true financial independence.
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DISCLAIMER: Nothing in this post or on this website is meant to be taken as personal financial advice. You are responsible for your money.