Living off investments defines financial independence, but getting there can be challenging.
How much money do you need to live off investments? Here’s the formula: Divide the desired annual income by the expected yield. If you want $10,000 monthly investment income, and expect a 5% yield, divide $120,000 by 5% for the amount of money you’ll need to live off investment income, or $2,400,000 in this example.
This is the simple formula to show how much money it will take for you to live off investment income only since yield is a measure of the income an investment generates.
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 we stumbled into early retirement in late midlife, we pondered how much money we needed to live off our investments. Knowing we didn’t want to begin depleting our savings, we began creating diversified income streams and did so over the next 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 before attempting to live off your money.
There’s some super important risk related factors you don’t want to miss so be sure to read this entire post.
Beyond Investment Income
We all love simple formulas. However, there are several more factors you’ll want to keep in mind as you use the formula above to estimate how much money you need to live off investments.
First, the reality is that traditional investment income alone doesn’t generate enough money for most people to live comfortably in retirement. You can see that for someone with $2,400,000, making $10,000 a year is achievable since a 5% annual yield is doable for proactive investors. Yet studies show that most people don’t have anywhere near $1,000,000 put aside for retirement, let alone over $2 million.
Additionally, most people aren’t getting a 5% yield on their investments, particularly given the popularity of index funds, which usually have very low yields.
Second, the norm in retirement planning is to withdraw and live on a set percent of your investment accounts. These withdrawals typically have to dip into more than just investment income for almost everyone, unless investors have chosen to invest in higher yielding investments, or they have a lot of investment capital earning income.
As a result, capital gains and maybe even invested capital (aka, your hard earned savings) are needed to live in retirement for most people, in addition to only investment income.
In order to make sense of all of this, let’s explore the layers of your nice, prosperous investment account, which I’ll equate to a chocolate layer cake.
Investment Income, Capital Gains and Savings
Investment income, capital gains, and invested capital can be thought of as different layers of your investment accounts.
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. That’s because steps can be taken to increase income from investments or elsewhere freeing you from the need to continuously dip into the capital gains and savings layers for large amounts.
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 age you choose. Like you may do, I equate living off investments to financial independence and/or retirement without financial struggle or worry.
Living Off Stocks and Bonds Only
In this post, first I’ll focus mostly on living off investments in stocks and bonds since these are the most common investments.
The reality is, 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.
I’ll 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 investments and alternative income streams.
Potential Income From Living Off Investments
|Money Available||Yield||Investment||Potential Assets|
|$2,400,000||5%||$120,000||High Yield Assets|
|$1,000,000||10%||$100,000||Covered Call Strategoies|
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 really 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 or wealth management fees).
If you have $500,000 earning 3% in dividends, the income generated will be $15,000 a year.
A 3% income yield from traditional stock and bond portfolios is realistic if not overly optimistic these days. The yield 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. Capital gains are the increase in value your investments have had, not the income they generate.
Most people who live off investments, however, don’t just rely on investment income for several reasons, as I’ll explain next in more detail.
If you’re confused about this, click here to read my post How to Understand Your Investments.
First, however, let’s dig into exactly what those layers of investment income, capital gains, and savings (or initial deposits) are.
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 that layer cake to demonstrate this point.
Envision 3 wealth layers in your investment accounts, again, much like in a chocolate layer cake.
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 only the income that your investments generate for you.
Think of this as the very top layer of that cake which is made up of all chocolate. The top layer of icing is usually thinner than the other layers, but we all know it’s the best, 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.
It’s literally like having your cake and eating it, too.
But much like getting a fork and scooping off that top layer of rich icing, there’s a drawback. The drawback is that living off investments from income only isn’t going to give most stock and bond investors much income to live on.
As you can see, having enough to live well requires a very high amount of money in your investment accounts, high yield investments, or both to generate enough income for most people to live. This has been compounded by the fact that over the past decade, interest rates have dwindled to nothing.
This is only one of many reasons why the old retirement model of 4% withdrawals is less reliable than it was over two decades ago when it first became popular.
Investment Yield and Account Size
As you can see from the formula and 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 determines 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 required a shift in thinking about retirement investing that hit us square in the face two decades ago! This awareness led us to shift into more than a traditional stock and bond portfolio based on standard asset allocation.
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 3% from dividend income on $1,000,000, or $30,000 a year, but let’s expand on this formula into more alternative investments. Remember, we’re looking at income only, not capital gains. Doing so allows for the potential to live off investments while leaving the capital intact to compound, and/or use when you’re 85, not 65!
Account Layers for Living Off Investments
|Income||Stock Dividends, Bond Interest|
|Capital Gains||Increase in Asset Price|
|Capital||Initial Deposits into Account|
Higher Investment Yield Examples
For an investor with $1 million in higher yielding stocks and “slightly” alternative investments such as preferred stocks, higher dividend stocks, maybe some MLP’s or 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 almost all bonds.
Let’s look at another example of income generating investments. Real estate is a little more complicated due to financing, expenses, and tax benefits, but let’s take a simplified example to prove the point.
An investor with a million dollars in real estate rentals yielding 10% after expenses would make $100,000 a year in investment income.
Another example is a stock investor who sells covered calls on stock holdings. She could easily generate income of 10% a year from selling call options on $1 million invested in stocks, earning $100,000 a year. Selling covered calls will be covered more later in this post.
Remember, the amount of investment income is a function of investment yield and the amount of money you have invested in income generating assets. We can simply shift the yield variable to have a meaningful impact on how much money you need to live off investments.
The income impact of this can be comparable to the result from a decade or more of constant efforts to save money and invest it.
Note that for most traditional, passive stock and bond investors, the yield on a diversified portfolio is about 2% these days, if that much. And even most income focused stock funds only yield about 2% to 3% as of this writing. Again, bonds yield almost nothing and have serious inflation risk.
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 and carefully selecting quality, higher yielding investments if you choose to live off investment income only (instead of spending down your savings).
Such proactive investors can get higher yields making it easier to live off investments with less money saved.
Now we’ve addressed why the investment yield is so important in determining how much money you need to live off investments. We’ve looked at the rewarding but slim income layer of your investment accounts. Next, let’s explore the next layer which can serve as an excellent retirement income source backup.
Layer 2 – Investment Income Plus Capital Gains
Let’s say that, like most investors, the income generated from your investments is not providing enough income to live. This means you’ll need to dip into the next layer.
At the next layer down, you’ll withdraw at least some capital gains (growth) from investments. And this can work fine for a lot of investors, especially during long bull markets.
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 and eventually run out of money, or, at the other extreme, live too frugally to enjoy life.
Referring to our layer cake example again, Level 2 is that rich creamy center. It’s not the lower foundation layer (your savings deposits), but it’s not exactly the income layer either.
Importantly, level 2 has the increase in value of your investments (capital gains) in it. You’ll want to make a conscious decision if you’re comfortable living off (spending) at this layer.
An ideal situation when living off investments is spending all the money from the top, or income layer first, then dipping into Layer 2 when needed, but not consistently.
The longer you’ve been investing in assets that are increasing in value, the bigger layer 2 will be, as you’ll see below. Over decades, for example, the value of stocks can increase significantly, making that middle layer huge.
This is building wealth from stocks. As you can see, however, it can take decades of discipline as well as favorable market and economic conditions to accomplish.
Again, 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 increased to $150 a share, you have a $50 capital gain.
It’s important to note at this point, that if you sell the stock you’ve had a realized capital gain. If you continue to hold the stock after it has increased in value, you have an unrealized capital gain, which can subsequently be lost if the value declines.
Example of Living Off Income and Capital Gains
Let’s bring this home with a real example of living off investment income and at least some capital gains.
Say that you make $5,000 a month from stock dividends in your retirement savings account. Let’s also assume this is your usual monthly spending from your investments. In other words, you’re living off dividends. (To keep it simple, let’s pretend the dividends are distributed evenly each month, which isn’t common in reality.)
Every year you take a nice trip. One month, you decide to take a trip to Europe with your entire 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 total.
You got the $5,000 dividend income which is already applied toward your usual monthly expenses that month. 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 $10,000 worth of Apple stock.
As a result, you have a $10,000 (realized) capital gain in this example. You’ll use this money to fund your trip. In addition, you used $5,000 investment income to pay the usual bills at home that month.
Your total expenses of $15,000 that month came from both the usual 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 also that particular 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’ve 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 popular in traditional retirement planning (in addition to annuities) so I’ll address it here. As you may be seeing, the ideal (but not most popular) plan for most retirees is to live off investment income rather than withdrawing retirement savings so they don’t have to spend down their savings, especially if early retirement is taken.
If you want to know how much investment income you have, and how close you are to living off your investments, 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 occasional periods during 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, forcing retirees to spend investment income, capital gains, and possibly also their initial savings deposits.
Fortunately, years of both investment income and capital gains compounding can often at least partially remedy this situation.
Sequence of Returns Risk for Retirees
The other factor influencing how much money you need to live off investments is, of course, 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 accumulated and compounded capital gains. An investor that frequently buys and sells stocks probably won’t. The investor with the higher turnover may, however, have reinvested those capital gains into more stocks, or elsewhere, thereby increasing net worth.
An investor who invests a large amount just before a bear market, however, will also likely incur capital losses (unrealized or realized) in his account.
This is such a real factor that it has a name, Sequence of Returns Risk. Studies show that if an investor experiences a bear market just before or after retirement, it would decrease the probability of her retirement money lasting for the planned retirement withdrawal period.
In other words, stock market cycles in the years both before and after retirement are important. They are also, unfortunately, out of our control.
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) or assets that tend to go up during recessions or bear markets to live. This is why it is so important to have a portion of net worth in investments that are non-correlated (move in opposite directions) to stocks, especially when living off investments.
As stocks become overvalued during bull markets, it can even make sense to increase cash, bonds, or other assets, even though the returns are sometimes lower in the short term. This is counter-intuitive when stocks are soaring, but it naturally reduces investment risk and provides a bigger cushion during bear markets, and may even lead to gains rather than poor performance.
Having money allocated between stocks and bonds is one major virtue of passive investing with a standard asset allocation model since quality bonds usually rise during stock bear markets.
Bonds Vs Cash for Investment Funds
Which assets increase in value during bear markets?
Again, a typical asset allocation based portfolio includes bonds. Since U.S. Treasury bonds increase in value when stocks decrease in value (or have in the past), bonds may well provide capital gains.
Many investors think of gold as a defensive asset. Gold frequently rises during bear markets, but hasn’t done so as consistently as bonds. You can read about this in my post Stocks That Went Up in 2008, Bonds and Gold.
You can also watch my video about gold and bear markets.
Now let’s look at Layer 3 of your investment accounts.
Layer 3 – Income, Capital Gains Plus Savings
As touched upon earlier, 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 economic and market conditions are favorable for this and for high net worth individuals with large investment accounts.
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
It’s worth repeating that masses of investors are invested in index funds that have a dividend yield under 2% as of this writing. This means that there is little income generated on most investment portfolios.
This problem can be solved by shifting some funds to higher yielding dividend stocks, funds, or other higher yielding assets.
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 can provide an excellent source of mostly passive income. If done inside an IRA, it can be done without the risk of triggering capital gains on long term stock holdings if the call options are exercised.
Of course, the income will be stuck inside the IRA but it can be coordinated with Required Minimum Distributions, when appropriate, as a solution.
Even if taxes are incurred, selling covered calls can make that top income layer over twice as thick. Again, 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 not increasing stock market risk.
Just remember the catch is that the covered call writer may miss out on capital gains IF the stock rises in value over the option strike price. The call income, however, is a bird in the hand while the potential capital gain is in the bush.
The most popular and conventional plan for retirees to live off investments is with retirement withdrawals so let’s address that further next.
Retirement Withdrawal Methods
It’s important to address retirement withdrawals in more depth 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 as the leader, or CEO, of your wealth.
Retirement 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 (increased) for inflation, each year to live. This method has been very common since the 1990s for retirees.
With this method, a retiree withdraws 4% from their investment account each year to live. The amount is adjusted for inflation annually, adding to the uncertainty of the retirement withdrawal method.
2% Retirement Withdrawal
It’s important to note that many view the 4% withdrawal rule as too aggressive. Further research showed that a retiree withdrawing 4% may run out of money if retirees ran into another troubling decade like the 2000s decade. This would trigger Sequence of Returns Risk for many retirees, as covered earlier.
This is because Layer 2 disappeared for many retirees! And layer 3 has been affected since due to lower interest rates.
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.
How You Feel About Living off Investments from Income Vs Capital Gains Vs Savings
Let’s pull all this together.
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. You’re spending what your money is earning for you.
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. You can estimate that now with your investments, or check the previous year’s brokerage statement from your investment accounts to see how much investment income you made last year.
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 1 and 2, can, however, can work if either the investment account has significant funds or if capital gains are consistent and above average. This emphasizes the importance of good investment returns.
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, capital gains, can take years to increase for most investors. Alternately, it can be done with successful proactive investing in shorter time frames. Remember, though, that there are many factors beyond our 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.
If you feel discouraged, know that it, too, can increase significantly by creating new skill based income streams, proactive investing or lifestyle changes, such as downsizing. (We gradually completely replaced prior job income with our alternative income streams.)
Opportunities to Live Off Investments
You may feel discouraged that you’ll never be able to live off 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’s someone else’s responsibility, such as the government, your financial advisor, or employer, for you to be able to live off investments one day, which is simply “retirement” by another name. This mindset is leftover from the previous generation when corporations or the government often did provide more retirement funding, life spans were shorter, and bond yields were higher.
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 these options have created wonderful opportunities 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 stockbroker, 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 quality high yielding stocks within a weekend.
And thinking a little more outside the box, you can create an online business for $25 that reaches a global market where you can sell your skills or products.
With this information comes the power to heavily influence 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. Then go for it.
Living Expenses Are the Foundation for Living Off Investments
Thus far, I’ve focused on incoming vs outgoing money, or expenses. That’s where I prefer to focus because the upside is much bigger with generating income vs cutting expenses. Continuously cutting the budget has limited potential and, quite frankly, is no fun.
In our experience, increasing income streams has been very enjoyable.
It’s true that 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.
Two More Investment Layers
There are two more layers that need to be mentioned that are a part most investment accounts. I’ve touched on these I but want to expand on them. They are not clear layers, but they are super important to consider, especially if you’re trying to live off investments now or later.
Compounding Income and Gains
Instead of layers, this “ingredient” is comingled into the existing layers. It can have a powerful effect on how much wealth you accumulate.
It’s compounding. The money you deposit compounds from both the income and the gains. The more money you spend, the less there is to compound.
Compounding has a major impact. It’s comingled into your other layers, and it builds wealth without work. We can equate compounding to sprinkling in chocolate chips.
Investment assets increase in value simply due to inflation. This is somewhat inconsequential since there is little you can do to control inflation. It’s important to realize this reality, however, because the increase in asset value due to inflation isn’t real.
Not only that, but investors end up having to pay taxes (and fees) on value increases due to inflation, unfortunately. Investors, however, are not getting the real benefit of this increase in value because their money has decreased in value by the amount of inflation.
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.