If you’ve worked hard to build up a large IRA or 401(k) balance, one of the scariest things you might ever do is actually start taking withdrawals.
In other words, you’d think saving that money was the hard part. But in reality, tapping your retirement nest egg can be an even bigger challenge because you might have that nagging voice in the back of your mind saying “But what if I run out?”
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If the idea of depleting your savings scares you, and understandably so, then you may be inclined to try living off of portfolio earnings alone in retirement, as opposed to touching your portfolio’s principal. And that logic makes sense.
Let’s say you have a $2 million IRA at the time you retire, and you earn $80,000 a year in dividends and bond interest. If you’re able to cover your costs with that $80,000 — which may especially be doable if you’re also getting Social Security — you can theoretically leave your $2 million principal alone. And if you don’t touch that principal, you can’t run out of money.
It’s a plan that could work. But whether it works well is a different story.
Some flaws to be aware of
While living off portfolio earnings alone may be doable if you have a lot of savings and modest income needs relative to the size of your IRA or 401(k), one thing you should realize is that your portfolio income isn’t guaranteed.
It’s true that bond issuers are contractually obligated to make interest payments. But issuers could default. And while companies with a strong history of paying dividends are likely to continue doing so, they can also cut or even eliminate their dividends during recessions or in other situations.
Another thing to realize is that inflation could erode your buying power over time. A portfolio generating $80,000 a year in income may be sufficient to cover your needs right now. In 15 or 20 years, that may no longer be the case.
Also, while it may be possible to live on portfolio earnings alone, doing so could mean denying yourself opportunities you deserve to have.
Let’s say you receive $30,000 a year in Social Security benefits plus get $80,000 from your portfolio. That may be enough to pay your expenses. But if you want to take a few nicer trips early on in retirement while your health is strong, you might need a higher withdrawal rate temporarily.
That’s something you shouldn’t deny yourself if the market isn’t down. But it could mean having to access your portfolio’s principal.
A different approach to retirement income
Living off of portfolio income alone is possible, but it’s not guaranteed to be a successful strategy. What you may want to do instead is take a total return approach to retirement plan withdrawals. In other words, rather than say you’ll only live on earnings, aim to live on total returns, including gains.
Another thing you may want to do is use a bucket strategy to manage your income needs. This has you separating your assets into a short-term, medium-term, and long-term bucket.
The short-term bucket should consists of safe assets like cash and Treasuries. It should be designed to cover your expenses for one to three years.
The medium-term bucket can hold assets like dividend stocks and intermediate-term bonds. And the long-term bucket can hold growth-oriented and broad market ETFs (exchange-traded funds).
If you adopt this approach, you may find that you have more flexibility with what you can withdraw from your savings. And that could make living off of your nest egg a less scary proposition.
