Let’s discuss how to live off investments. Then maybe you can retire!
Perhaps you have enough government-backed social security income. Or, plenty of employer-sponsored pension income to support your retirement. If you do, congratulations!
But most of us do not. So, let’s go through the key steps to answer the question: can you live off investments?
I retired early and live off investments. Hopefully, I can give you some tips based on my experience.
Let’s get started learning about this important money management concept.
How Much Income From Your Investments Do You Need?
Step 1 – the first question that must be answered is how much income do you need?
There are a couple of ways to determine how much income will be necessary for retirement.
Related: How to determine when you can retire
How To Live Off Investments – Estimating Expenses – 80% Rule
This rule states that you need 80% of your work income in retirement.
So, if you make $50,000 per year. You will need $40,000 ($50,000 x 80%) of income when you are retired.
Why 80%? The rule assumes some of your costs will be eliminated during retirement. For example, you will not have commuting costs for work. Or, need to update your “dress for success” wardrobe.
The 80% rule is easy to apply. It can give you a quick answer. But it does oversimplify things.
Let’s look at another method.
How To Live Off Investments – Estimating Expenses – Track Them
Tracking your expenses every month is a great personal finance habit. Going beyond retirement planning, expense tracking allows you to know exactly where your money is spent.
Can you reduce expenses if you do not know where you spend your money? Besides, expense tracking is really helpful for retirement planning.
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Review your annual expenses during your working years. Then remove expenses no longer necessary in retirement. I already mentioned commuting and clothing costs. Perhaps you won’t be dropping $7 a day on lunch out with your co-workers either.
Next, don’t forget to add in new spending now that you are free of that 9 to 5 job. Higher travel costs come to mind if traveling more interests you.
Also, add in health insurance costs if you are not qualified for government-sponsored health care.
Will you still have debt payments? Make sure to take those into account.
Finally, don’t forget about income taxes. Just because you are no longer working doesn’t mean you won’t have to pay income taxes.
How To Live Off Investments – Estimating Expenses – Other Income Sources
So now you know how much your expenses are. But before we move on, subtract from your estimated expenses other sources of income besides your investments.
I have mentioned a couple of those potential sources already: social security income and pension income.
Maybe you will have other sources of income, like a part-time job or a side-gig. But, social security and pensions are the big ones for most people.
A little extra income can go a long way to being able to live off investments.
Now we are ready for step 2: choose a withdrawal method for living off your investment portfolio.
3 Withdrawal Methods To Live Off Your Investments
I’m going to discuss three methods for how to live off your investments:
- Interest-only – living off savings
- Diversified passive income – how to live off interest and dividends
- Income and principal – 4% retirement withdrawal method
How To Live Off Investments – Interest-only method
By definition, the interest-only method has the retiree living off the interest from savings products.
Your principal amount, also known as your original investment, is never touched. Collect a steady stream of interest payments to cover your expenses in retirement.
Living Off Savings – Types of Savings Products
What types of savings products am I talking about? Mostly conservative assets. For example:
- Savings accounts
- Certificates of deposits
- Savings bonds
- Money market accounts
How To Live Off Savings – Advantages & Disadvantages
There are a couple of advantages to the interest-only method of living off your investments.
First, it is simple to implement. Furthermore, there is very little risk of loss to your original investment. You can go to bed at night knowing your life savings are very safe.
On the other hand, there are some disadvantages to the interest-only withdrawal method. The main one is ultra-low interest rates. A lot of excess capital is necessary to make this method work.
For example, the interest-only withdrawal may result in an average interest rate on your savings of just 2.5%. To generate $25,000 per year of retirement income, a retiree would need to be living off the interest of 1 million dollars in savings.
Finally, inflation can eat into the spending power of interest only income over the long term. The living off savings plan will not keep up with inflationary increases in your expenses.
How To Live Off Investments – Diversified Passive Income Method
With this method, we are talking about building a diversified investment portfolio of assets that generate income.
Thus, we are building an income portfolio. This is also known as investing for income.
Similar to the interest-only method, the plan is to never touch the principal. On the other hand, we are going to broaden out the potential assets available for our investment dollars.
Living Off Your Investments – Income Investments
What types of investments should be included in an income portfolio? Any of the savings products from the interest-only portfolio are appropriate. But we want to include some others.
Here are some examples:
- Investment-grade corporate bonds
- High yield corporate bonds
- Preferred stocks
- Dividend stocks
- Exchange-traded index funds (ETFs) that pay dividends
- Real estate rentals
Living Off Your Income Investments – How Much Of Each Asset Class?
How much of each asset class should you buy? Well, that depends on your risk tolerance. On the other hand, we need to take more risk to generate enough income to support our retirement.
So, I would say a model asset allocation might look like this:
- 10% – Savings products
- 20% – Real estate
- 20% – Bonds and preferred stock
- 50% – Dividend stocks and ETFs
This model is just a starting point. You need to adjust the allocation for your situation.
Living Off Your Income Investments – Advantages & Disadvantages
There are some advantages to a diversified income portfolio of assets versus an all interest portfolio. First, it is possible to earn higher rates of income. I think 4% is entirely possible without taking on too much risk. With a little more risk, 5% is also possible.
Going back to our previous example, let’s say a retiree has 1 million dollars saved up. Earning 4% provides $40,000 in annual income.
There is another advantage to investing for income. Passive income from dividend stocks, exchange-traded funds, and real estate may increase over time. This helps a retiree’s income keep up with inflation.
There are also a few disadvantages to the diversified income approach. First, you need to know a little bit about investing to put your money in all of those asset classifications.
Second, there is a potential for loss of principal. Stock, bond and real estate values do not always go up. That said, if you only spend the interest and dividends, fluctuating asset values should not be an issue.
How To Live Off Investments – Income And Principal method
This method is most commonly known as the 4% safe withdrawal rate.
This rule merely states that a retiree can withdraw 4% from their investment portfolio each year for expenses. Each year the withdrawal can be increased for inflation.
The withdrawal will be composed of interest, dividends, and principal. The expectation is the principal will grow over time to at least partially replace the withdrawals.
4% Safe Withdrawal Rate – Types Of Investments
Typical investments would include a mix of growth and income. It could be as simple as this:
- 10% – savings products
- 30% – a diversified bond exchange-traded fund
- 60% – S&P 500 exchange-traded fund
Advantages & Disadvantages Of The 4% Safe Withdrawal Rate
This method has been backtested and shows a high probability that a retiree will not run out of money. And it is fairly easy to implement.
Just like the diversified passive income method, 1 million dollars in assets will generate $40,000 each year to cover expenses.
On the other hand, the retiree must be comfortable selling down part of their investment principal on an annual basis to fund those expenses.
Living Off Investments Is Not Easy
These examples show that it is not easy to live off investments. To get $40,000 per year for expenses, a retiree needs around a million dollars.
That would make you a millionaire. And statistics show that less than 2 out of every 10 households in the US have a million-dollar net worth.
Do You Want to Live Off Your Investments Some Day?
If you are not able to live off your investments right now, then start doing the right things today, so you can live off investments in the future.
Activities while you are still working:
- Track your expenses
- Reduce expenses in areas where you are able to do so
- Look for ways to increase your income
- Save more to build up your investable assets
- Position your savings and investments with an eye toward your preferred withdrawal method
- Work longer
Activities when you are retired:
- Work part-time
- Start a side-gig
- Maximize social security and pension income
- Find a more affordable place to retire
- Track, manage and reduce expense where possible
Many people dream about having enough money to live off investments. Start planning today so you can live off investments in the future.
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