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IRA and 401k: Generate Retirement Income with Just Interest and Dividends

My post last Monday kicked off a new series which advocated using IRAs, 401k plans, and other retirement savings to generate a lifetime monthly paycheck, and it summarized three ways to generate retirement income:

  1. Invest your savings, and spend just the interest and dividends.
  2. Invest your savings, but draw down principal cautiously so you don't outlive your assets.
  3. Buy an immediate annuity from an insurance company.
In this post, I'll explore the first method in greater detail -- spending just interest and dividends. With this method, you don't touch the principal; instead, you use just the investment income to pay for living expenses.

First, let me emphasize the importance of using a diversified portfolio of both stocks and bonds in your IRAs and 401k for the purpose of generating retirement income. Retirees who invested exclusively in bonds or CDs experienced precipitous declines in income in the last several years, as interest rates on these types of investments have dropped due to the economic downturn.

But the dollar amount of income from a diversified portfolio of stocks and bonds hasn't experienced such a drop, although there have been moderate fluctuations in the past decade. (For details on how you could have used this strategy to survive the "lost decade" from 2000 to 2009, see my recent post Recession-Proof Your Retirement Savings.)

A related word of advice: Don't just seek the highest-yielding investments for the purpose of generating retirement income. Selecting only the highest-yielding bonds, CDs, and other fixed income investments can lead to significant declines in income, as noted above. In addition, resist the temptation to invest in stocks with the highest dividend yields; they're often paid by struggling companies that are due for a fall.

There are many balanced or target date mutual funds that guard against these risks, because they invest in a diversified portfolio of stocks and bonds. These funds will generate annual dividend payments that currently yield between three and four percent of assets, depending on the specific asset allocation. Payout rates of three to four percent are good goals for using this strategy to generate retirement income, and you can apply these percentages to your retirement savings to estimate how much annual income you might receive.

Note that the amount of your income can increase or decrease from year to year, depending on interest rates on bonds and whether the stocks are increasing or decreasing their dividend payouts. While there's no guarantee that your payout will keep up with inflation, the goal is that the increases in stock dividends will hedge against inflation.

The mechanics of using just interest and dividends to pay for living expenses are pretty simple, particularly if you use mutual funds. You simply specify that the income be deposited electronically in your checking account. You don't need to decide which assets to sell to generate additional retirement income, which you must do if you're drawing down principal. Each mutual fund has different payment frequency -- monthly, quarterly, semi-annually or annually. If your fund's frequency is less than monthly, you'll need to spread out the income accordingly to calculate your monthly paycheck.

Using interest and dividends has other advantages:

  • You hold your principal in reserve for unexpected expenditures, such as long-term care expenses or emergencies.
  • You can leave the principal as a legacy to children or charities, if that's important to you.
One thing to keep is mind is that, compared to the other two methods of generating retirement income -- drawing down principal and buying an immediate annuity -- using just interest and dividends produces the lowest amount of initial retirement income. However, this drawdown method does offer flexibility: Down the road, you can always change to one of the other two methods of generating retirement income if you need additional funds.

In fact, I like using this method in your "early" years of retirement -- say in your sixties or seventies. During this period, you might not need to draw as much from savings because you'll be supplementing your retirement income with part-time work; when you're less able to work, you can shift to other methods of generating retirement income that produce higher amounts of income.

Another thing to keep in mind: If your retirement savings are invested in traditional IRAs, 401k, 457, or 403b plans, there's a good chance that the IRS required minimum distribution (RMD) rules will produce payouts that are higher than just investment earnings. You'll need to pay attention to these rules starting with the year in which you turn age 70-1/2. These rules don't apply to Roth IRAs, Roth 401k plans, or other invested assets.

Here's a summary that shows how this method of generating retirement income just from interests and dividends meets various goals, including the retirement income "trilemma" that was introduced in my previous post last Monday.

  • Amount of initial income: Low
  • Potential for growth in income: Depends on your asset allocation
  • Access to/preservation of principal: Yes, although you're subject to investment risk
  • Protection against investment risk: Depends on your asset allocation
  • Protection against longevity risk: Yes
  • Effort to set up: Moderate -- you need to select appropriate funds
  • Ongoing maintenance: Moderate --you need to periodically monitor investment performance
  • Ability to change to other methods: Yes
In future posts, I'll analyze and rate the other two methods of generating retirement income. It's well worth your time to learn about the various methods of generating retirement income from your IRAs and 401k accounts. After all, we're talking about your security for the next 20 to 30 years.

More on CBS MoneyWatch

IRAs and 401k: 3 Ways to Generate Retirement Income

Recession-Proof Your Retirement Savings - Part 1
Recession-Proof Your Retirement Savings - Part 2

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