Living Off Investments Vs Living on InvestmentsThere are two major ways to live off your money that need to be clarified as they affect how much money you need to live off investments.
Living Off InvestmentsThe first method is living off investments. With this method, investments generate enough income to live. Examples of such income are stock dividends, bond interest, annuities, REIT and MLP payouts. More alternative examples of income generating assets are covered calls, real estate rentals and small business. You’ll notice some of these assets provide passive income and some require more work.
Living On InvestmentsWith this method, investments are gradually depleted to pay for living expenses. The most common retirement withdrawal rates are 2% to 4% a year. This method is completely passive, but most of this money is not really income even though it is referred to as “retirement income”. In reality, it is simply spending the money in your retirement account in a methodical way.
The 4 Elements of Your Retirement AccountThat money in your retirement account came from 1 of 4 things:
- Deposits into Your Savings
- Bond interest and stock dividend income on those savings, generally at 1 to 3% a year.
- Growth (increase in value) from investments, particularly stocks.
- The compounding from the above.
Gray Line for Dividend IncomeAs you can see, your retirement account is partially comprised of dividends. So there is a gray line between dividend income when living on investments vs living off investments. This is because both methods have dividend income. Let me explain. Most people are invested in stock income funds that have very low yields in the 2 to 3.5% range as of this writing. This is true even for most “income focused” stock funds and ETF’s. On the other hand, an investor who has made a conscious decision to live off their investments vs spending their retirement savings would make the effort to invest in higher dividend stocks (personally or with a wealth manager) that likely double the dividend income received from most stock income funds. And then there is covered call income as addressed more below.
How Much Money You Need to Live ON Investments ExampleSusie has an ideal upcoming retirement scenario at age 55, unlike many investors. She plans to retire at 60. She does not care about leaving a legacy and has no dependents that may need some financial help. Having no family, she has been able to save a lot of money over more than two decades. Plus, Susie has done well in her career, where she focused most of her energy. Susie saved money each month, and she deposited her bonuses into her retirement savings account to grow and compound without taxes. There was even some employer matching of retirement funds many of the years which was a windfall for her. Smartly, Susie began saving early in her thirties investing in stocks and bonds using a passive standard asset allocation strategy, but only after first understanding the basics of investing.
A Million Dollar Retirement AccountAs a result of all the above, Susie’s retirement savings has grown to a million dollars. Given the strong rise in stocks during the decade leading up to age 55, Susie isn’t sure her retirement savings will have as high a return over the next 5 years until retirement as it has had over the past few. In her 40’s, Susie decided to hire a financial advisor so she could focus on her career vs worrying about her stocks. She hired a fiduciary financial advisor with reasonable fees that had demonstrated good results in the past. Based on her own investment knowledge, Susie felt confident evaluating the financial advisor she hired after interviewing several. At the suggestion of this financial advisor, Susie has recently taken some steps to reduce investment risk by decreasing stock holdings, increasing Treasury bonds and increasing cash significantly at age 55. They feel this will position her well for retirement by providing the funds to buy dividend stocks at lower valuations at some point over the next few years. This will position her well for both capital gains potential and higher dividend income as Susie sails into retirement. They also anticipate that her US Treasury bonds will rise in value once another bear market occurs offsetting some of her risk from stocks. This all makes perfect sense to Susie since she understands the basics of investing in stocks and bonds. You can read my article here What Goes Up When Stocks Go Down for more about this. Using a retirement calculator, she and her financial advisor see that there is a good probability her investments will grow to $1,432,782 when Susie plans to retire at 60. You can see this retirement calculator here on my website.
Return on Retirement Account InvestmentsTogether, Susie and her financial advisor plan for Susie’s retirement savings to generate a 5% return based on the factors below.
- Optimism over a proactive tactical investment strategy
- Concerns over an expected looming recession and the high probability of a related bear market
- Susie’s continued savings of $1,000 a month
The Math for Living on InvestmentsSusie’s financial advisor suggested a 3% retirement withdrawal rate which is smack dab in the middle of the common but somewhat dated (and perhaps overly optimistic) 4% Rule, and a lower risk 2% withdrawal rate that’s based on more recent studies including the bear markets of the 2000’s. The annual retirement withdrawal will vary in the years following year 1 in retirement since the withdrawal amount will be adjusted annually for inflation. The projected growth estimate shown above in the retirement calculator image can be used as a good rough estimate for how much Susie can expect to withdraw and spend in retirement from her savings account. Let’s use that growth estimate from the retirement calculator example above to see how much she would withdraw year 1 based on withdrawing 4%.
$1,432,782 x .03 = $42,983
Bear Markets in RetirementIt’s important to note that during the occasional but inevitable bear market, based on history the value of Susie’s retirement account could decline by at least 25% even though she has some hedging in place with her U.S. Treasury bonds. During such years, the amount she is withdrawing will increase as a percent of her portfolio only. This is because the withdrawal amount stays the same as year 1 except that it is adjusted for inflation each year. Let’s say a bear market happens in year one in retirement just to clarify how a bear market would affect Susie’s retirement withdrawal funds. Since we have no way of knowing how much inflation will be, we’ll ignore inflation to demonstrate this point only. If Susie’s retirement portfolio dropped by a reasonable 25%, it would be worth $ 1,074,586. She would still withdraw $42,983 (and any inflation adjustment). After the drop in her portfolio value, however, $42,983 is now 4% of her retirement savings.
(Retirement Withdrawal Yr 1) $42,983/(Retirement Savings) $1,074,586 = 4%So, Susie would withdraw a 4% of her retirement savings, plus compounded inflation. Then, if history repeats itself, the stock market would gradually recover over a few years. Based on history, it’s logical to assume her retirement savings will grow again, and eventually exceed the $1,432,782 Susie had when she retired. Assuming it does grow and compound more than she withdraws, the withdrawal amount of $42,983 may be only 2% or 3% of her retirement portfolio. Note that I don’t want to discount the important of inflation simply because I didn’t include in this example since it is an unknown. Recent historical inflation averages have been about 2% a year but some expense categories are not included in this calculation. After years of long hours and commuting with her job for decades, Susie is looking forward to simply living on investments in retirement with plans for travel and relaxation. She has decided that she can always begin consulting work should she get bored or need additional money but with the ability to choose her own schedule without the nasty commute. Read my related post Reducing Risks in Stocks.
How Much You Need to Live Off Retirement ExamplesNow that you’ve seen how much money you need to live on investments, let’s see how much money you need to live off investments. Gary and Joy are both 53 years old and ready to retire now but have decided to retire at 55. This will allow them to create another income stream plus save more money before retiring. They have saved about $700,000 over the years which is invested in stocks and real estate rentals. At age 50, they saw they would not be able to retire at 53 using a traditional retirement method such as the 4% Withdrawal Rule.
Creating Income Streams before RetirementAfter assessing their situation Gary and Joy got busy creating alternative income streams, taking their financial future into their own hands. Over the past 3 years, they have bought income generating assets based on their desire to not spend their retirement savings with the retirement withdrawal method until they are in their 70’s. At that time, they will reassess their retirement income strategies and the size of their retirement account. If they’ve learned anything from investing and life it is that you cannot predict exactly what can happen and when. Read my related post How to Increase Net Worth before Retirement.
Income from StocksGary and Joy have $300,000 in dividend stocks, REITs and MLPs yielding an average of 7% income a year. They sell covered calls on these same income generating investments for an additional 10% a year as opportunities arise. (I call this double dipping!) Read my related post entitled Are Covered Calls a Good Strategy? Gary and Joy know that covered calls work best during sideways and up stock markets so they manage them accordingly. They accept and plan for the fact that in some years during bear markets, they won’t have as much covered call income in retirement. This is why they have bought dividend paying stocks and other assets so they will always have at least some stock income from dividends and other liquid asset payouts, probably around 7%. But fortunately, they are selling out of the money covered calls on stocks they have owned for years that cost much less than market value. For this reason, they should be able to continue to generate covered call income even during bear markets since their stock cost is low. The total income from selling covered calls and dividends is $30,000 a year, or $2,500 a month. Read my related post Problems with Covered Calls.
Dividend and Covered Call IncomeFor some time now, they have been putting their dividend and covered call income into a money market each month since the economy appears to be headed into a recession in the not too distant future. They know a bear market is likely to occur in relation to the expected recession based on historical facts. They have been selling covered calls inside an IRA so they have been able to avoid paying taxes on the covered call income thus far. They plan to write covered calls inside the IRA at least until they retire at 55. While Gary and Joy know they will probably live long enough to experience several bear markets in retirement, they aren’t too worried since their income will cover their living expenses. As a result, they won’t need to sell stocks during bear markets. Read my related post How Will a Stock Market Crash Affect You?
Increasing Retirement Savings While EmployedSince they still have employment income, Gary and Joy have a rapidly increasing $100,000 in a money market earning 2.20% a year, or $183 a month. They like having a high percentage of portfolio cash since they feel assets are overvalued. Read my related post What Percentage of Cash Should Be in My Portfolio? They use the money market income generated to pay for an assistant to do bookkeeping related to their investments since they work full time. They plan to outsource this work in retirement, too.
Income from Real EstateGary and Sara bought two duplexes with down payments totaling $ 300,000. Their total rental income on the duplexes after all expenses and financing is $ 1,500 a month. Fortunately, they cut a deal with a tenant to do the yard work and maintenance, so this is mostly passive income. The properties were a smart buy, and thus they have increased in value, making them both an income generating asset in addition to a wealth building asset. This increased Gary and Joy’s net worth since they bought them at less than market value several 3 years back. Of course, the real estate also has tax advantages which is important since they both earn employment income.
Home EquityThey feel good about their home equity of $ 300,000. Should their retirement plans get off track after they retire at 55, their home equity can provide Plan B. Since they make a better return on their money than the cost of the 4% financing on their mortgage, they have kept their remaining mortgage. Since Gary and Joy’s salary covers their living expenses, they are putting (or keeping) all of their income from the various income streams in their savings accounts. Gary and Joy feel comfortable that with all their alternative income generating assets, they will be able to easily cover their lifestyle expenses in retirement. Since they proactively invest in undervalued assets, they expect that their net worth will increase over the years even though they will live off investment income after they retire at 55. Read my related post How to Buy Assets That Generate Income. Gary and Joe enjoy the stimulation of investing, so they anticipate continuing to proactively invest in retirement instead of doing cross word puzzles as they age in the years ahead.?
Summary for Money Needed to Live Off InvestmentsAs you can see, living off investments and living on investments are different methods for living with financial independence. While dividend income crosses into both methods, the amount of money needed to live off investments will vary greatly depending on whether you choose to withdraw from savings in retirement or, instead, focus on income generating assets.
The information on this website is for education only and is not to be construed as personal financial advice.