You may be wondering how to live off investments, especially in this day and age of extremely low interest rates when your investments don’t earn much income.
Individuals live off investments in one of three ways: spending investment savings and it’s growth or income, spending only the income generated from investments, or living off a combination of investment savings and investment income.
Most people think of living off investments as retirement, or being very wealthy. Years ago, I ran the numbers to see how we could eventually live off investments during retirement.
After almost 40 years of investing my own money, and creating diversified income sources over the past 15 years from stocks, real estate and online businesses, here’s what I discovered about living off investments before and in retirement.
Retirement Withdrawals Vs Diversified Income Streams
The traditional retirement plan calls for withdrawing your money to live. This became the normal way to retire as pension plans became less common.
Retirement withdrawal plans have become less reliable with longer lives, inflation, and low interest rates.
Below are the three strategies now for living off investments in more detail.
- Spending Your Money, or the “Investment Withdrawal Strategy” – The first way to live off your investments is by saving enough money with the plan that money will grow and compound. The hope is that you can eventually withdraw funds from your investment accounts to pay all your bills, usually later in life.
- Spending Income Investments Generate, or the Income Streams Method – The second way to live off your investments is to own income generating assets, such as stocks, bonds, real estate or small business. Owning assets that generate cash flow allows you to pay the bills with the income you get from these assets.
- Investment Withdrawal and Income Streams Combination – The third way to live off investments is a combination of using both funds withdrawn from your investment accounts and the income that is generated from assets that generate cash flow.
How to Live Off Investments With Withdrawals
As previously addressed, the most common way to live off your investments in retirement is by saving enough money so you can withdraw funds from your investment accounts to pay all your bills each month.
There are several popular retirement withdrawal strategies with varying withdrawal amounts. One of the most common methods is withdrawing 4% each year from your investment accounts.
Another method, which became popular after the two huge bear markets in the first 2000 decade, withdraws 2% to 3% a year.
There are several other retirement withdrawal strategies that are based on the performance of the financial markets or investment portfolio performance. All these methods are based on spending the money in your investment accounts to fund your lifestyle expenses.
While retirement withdrawal strategies are referred to retirement income strategies, they really involve spending down investment accounts that have usually grown over the years.
Assumptions About Your Retirement Investment Account
There are some basic assumptions about using the withdrawal strategy to live off your investments.
1. The investment withdrawal strategy assumes your investment accounts will appreciate over the time you are withdrawing from them. This appreciation may come from interest, dividends, or capital gains. It could also come from compounding of investment income and gains, or even initial deposits.
2. It further assumes your withdrawals will be less than the increase in value of your portfolio for at least most years.
3. It also assumes your investment accounts will be earning at least some level of income from dividends or interest. These are valid assumptions, especially for very long periods of time.
You’ll want to personally confirm, well before retirement, that this strategy will work work for you. Do the math. Use a calculator. It’s your lifestyle that you’re needing to support for life.
Read my related post How Much Money Do You Need to Live Off Investments?
Here’s my video on how retirement withdrawal strategies work.
Good Things About the Investment Withdrawal Strategy
Withdrawing money is simple. There is no work involved beyond the usual wealth management tasks of tracking your money, choosing investments funds or hiring and evaluating financial advisors, taxes and banking.
Disadvantages of Retirement Withdrawal Strategies
This is my least favorite method for living off investments. Below I’ll explain the reasons.
Withdrawing from Investment Accounts During Bear Markets
A big problem with most retirement investment withdrawal strategies is that you will probably need to sell securities at or near multi year low prices during occasional bear markets.
This is because the average bear market lasts for about fifteen months. Here is an excellent chart of the history of bear stock markets.
The early 2000 bear market lasted 2.1 years. If you’re withdrawing money monthly, you’ll either need to sell securities during the market lows or have enough money in cash to outlast the bear market.
Note that some financial advisors suggest having up to two years of living expenses in cash type of investments to avoid having to sell during bear markets. This makes sense since the longest bear market in the early 1930’s lasted 2.8 years.
As you can see, the withdrawal strategy involves some analysis and insights.
You can read more in my post How Will a Stock Market Crash Affect You?
Fortunately, bull (rising) stock markets are much more common than bear (falling) markets.
Building Wealth Tip – While there is a very popular video that explains how everything you need to know about investing can be explained on a cocktail sized paper napkin, after almost 40 years of investing, I question this theory.
The Withdrawal Strategy Fuels Scarcity and Lack
What we believe deep inside affects our actions. Most people feel some guilt or remorse about withdrawing from their investment accounts to pay for their living expenses unless they have extremely high net worth.
Even those with very high net worth have grown their spending to match their level of wealth. This means that making withdrawals to live off investments is not always easy even for those with plenty of funds.
Most of us are conditioned our entire lives to save money and put it into our investment accounts. Suddenly, in the last half of our adult life we’re supposed to feel good about spending this money.
How can you really justify that long awaited cruise expense when, deep down, it feels wrong to spend money you may need for paying the electric bill one day?
Economics, Financial Markets and Politicians
Predicting the amount to withdraw when living off investments can be hard. Estimates for inflation, longevity, and investment returns must be based on estimates.
What if your estimate is wrong for the withdrawal strategy due to factors way beyond your control? The downside is huge since it can lead to running out of money.
Plus, the economy affects stock prices. What if there is another 57% drop in the S&P 500 stock index in the years just before or after retirement, for example? Research shows this can derail your retirement withdrawal plan.
Or what if there is a larger number of secular bear markets than usual during the period you plan to live off your investments?
These potential threats are not mentioned here to induce financial fear, an unhealthy emotion when it comes to your money. They are here to simply suggest using past data wisely to realistically plan a safe future for living off investments.
Financial independence and retiring early is wildly popular now, especially among those who have not yet experienced severe bear markets as adults with stock market investments.
As we headed into late midlife with conversations about living off investments, the tech bust annihilated the Nasdaq. This was followed by the nasty bear market of 2008 only a few years later. There was also the accompanying horrible recession and enormous drop in the value of real estate.
Let’s look at the two other ways to live off investments.
How to Live Off Investments with Income Streams
With the income streams method of living off investments, income generating investments are made so that the cost of living is covered from investment income.
Instead of employment income, investors live off investment income. The challenge is, of course, getting investment income high enough to cover living expenses.
Ideally, no withdrawals from savings must be made with this strategy.
To explain further, you have probably noticed that dividends received from owning stocks or stock funds are usually automatically reinvested? With the income stream method, you would choose to have the dividends not reinvested.
This money could then be used to pay bills to live.
Similarly, you’d also use the income from bonds or bond funds.
With this method, the primary goal for investments is to generate income.
Sometimes when an investor buys an income generating investment, it will increase in value, also.
Example Using Interest Off 2 Million Dollars to Live Off Investments
Here is an oversimplified example of the income stream method used to live off investments.
Interest off 2 million dollars in longer term bonds paying 4% is about $80,000 a year before taxes. (Again, there are many variables with taxes, so I won’t address them here.) This equates to $6,667 per month.
If this amount covers the investor’s lifestyle expenses, bond income could be all that is needed to live off investments without spending investment savings.
This is a simple example, especially since most investors would have the 2 million dollars in both stocks and bonds with the intention that growth would occur with the stock investments.
Alternative Investments to Live Off Investments
Here is an important, beneficial element that many people living off their investments miss: Alternative income generating assets can be used in addition to traditional stocks and bonds to significantly increase investment income.
Mainstream retirement plans usually only consider traditional stock and bond investments, however.
Benefits of Alternative Assets When Living Off Investments
There are many benefits from alternative investments as addressed below.
Diversification Lowers Investment Risk
Many investors seek alternative investments because they want to own assets besides traditional stocks and bonds. Alternative investments can add another layer of diversification to an investor’s portfolio.
Higher Yields from Alternative Investments
More unique alternative investments, such as real estate and small business, often generate higher income yields. They frequently have tax advantages, too, and provide residual income.
Living off investments can be completely passive. Many people enjoy the mental stimulation from owning or overseeing alternative investments.
Too, many alternative investments involve more work than simply collecting dividends, fulfilling that need for a little part time work once an investor has reached the ability to live off investments.
Wealth Building While Living Off Investments
One benefit of non stock investments is that those investments can increase in value significantly over the years while also paying out good income.
While this is also true of stocks, investors usually have more control with alternative investments such as real estate or small business. Plus, such alternative investments can also have more potential upside than most stock investments, particularly index funds.
This essentially allows retirees who are living off investments to take advantage of the income generated from their assets while also building wealth.
Not everyone will want to explore beyond simple stock and bond investments but alternative investments can enable retirees to live off investments rather than making retirement withdrawals to live.
The type of assets selected for living off investments will depend on the amount of income needed, the skills and interests of the investor, and the amount of capital the investor has. Every investor has to choose what works best for his own situation and desired lifestyle.
Many wishing to live off investments wonder if it is safer to withdraw or get investment income. The two methods are not mutually exclusive as you’ll see next.
How to Live Off Investments with Withdrawals and Income Streams
This method of living off investments combines the two methods above. It assumes that the investor has enough investment savings to generate enough income to cover most if not all living expenses and can also rely on retirement withdrawals when needed.
The combination method of living off investments has several advantages addressed below.
The combined income streams method gives the investor the opportunity to stay invested in growth assets. Growth may come from stocks, real estate or small business. Bonds can even increase in value when purchased strategically.
As mentioned, you may also be able to take advantage of tax benefits from alternative investments.
This strategy has a lot of flexibility to accommodate you if you want to have more, or less, passive income as you age, or when life plans change.
It allows you to keep steady income streams during bear stock markets and make minimal withdrawals than an investor without income generating assets.
The combination method also provides a great amount of diversification between the traditional financial markets for stocks and bonds, and nontraditional investments.
Diversification accomplished in this way reduces the risk of losing all your income, and easing potential net worth declines during bear markets. It’s a simple risk management strategy.
Financial independence is knowing how to live off your investments and doing it. As you can see, there are three main methods to accomplish this which all focus on getting funds from investing.
Again, you either spend your savings, spend the income your savings generate, or do a combination of the two.
Everyone must do what works for them in their pursuit to figuring out how to live off investments, the ultimate financial independence.
Read my related post How Many Income Streams Should You Have?
Read my related post Start a Business or Invest in Stocks: Which Is Better?
Read more about this in my related post How to Buy Assets That Generate Income.
First Trust Portfolios L.P.