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Undertanding interest and dividends in retirement planning

How much retirement income can you generate from your 401(k), IRA, and retirement savings? It's a critical question because it will affect just how much money you'll have to spend for the rest of your life.

The answer can vary widely, depending on a number of factors, the most important being the method you use to generate retirement income. Your age, sex and marital status also have a significant influence. And your income will depend on a number of economic factors, such as interest rates, dividend payout rates and annuity purchase rates in effect at the time you retire.

In order to help you discover the answer to the question I posed above, here's the first installment in 2014 of my retirement paycheck scorecard series. It shows you the amount of retirement income that can be generated from $100,000 in retirement savings (as of January 2014) for each of the three methods of generating retirement income I discussed in a recent post.

Interest and dividends only

One way to generate retirement income is to invest in a mutual fund that pays a regular dividend and then use just the interest and dividend payments to cover your living expenses. Because you aren't dipping into your principal, there's a good chance you won't outlive your money. This method also offers the maximum flexibility and access to your retirement savings.

The downside is this method produces the lowest amount of retirement income, as you'll see by comparing this scorecard to the next two scorecards in this series.

Shown below are the estimates of annual dividends paid from various Vanguard mutual funds that have regular dividend payouts. These Vanguard funds don't chase yield, which is another desirable goal in investing for a retirement paycheck. Stocks and bonds with high dividend or interest rate payouts contain risks that can result in subsequent depreciation in the value of your savings. I've also included the payout rate -- the annual income as a percentage of the investment -- for the purposes of comparing it to other methods of generating retirement income. 

Vanguard payouts Q1 2014.jpg

Compared to last installment in this series in mid-2013, the payout rates for the Wellesley, Wellington, Equity Income and Dividend Growth have declined slightly, while the payout rate for the REIT fund increased significantly. These changes are due to the net result of changes in dividend payouts and interest rates, and appreciation in the underlying fund values.

Note that these funds have different asset allocations between equity and fixed income investments, which is one important reason for the differences in income. The Wellesley fund is invested roughly 33 percent in stocks, with the remainder in fixed income or cash. The Wellington fund is invested roughly 63 percent in stocks with the remainder in fixed income or cash. The Dividend Growth and Equity Income funds are invested nearly 100 percent in stocks, while the REIT index fund is invested nearly 100 percent in real estate investments.

All but the Dividend Growth fund pay dividends quarterly, while the Dividend Growth fund pays dividends semi-annually. The above amounts assume the payout rates for the past 12 months will continue for the next 12 months. Your actual income will change to the extent that future dividend payments are increased or decreased from the past 12 months.

There are other mutual funds with goals similar to the Vanguard funds mentioned above. While these Vanguard funds have low expenses and favorable investment histories, I encourage you to do your own shopping with an online service such as Morningstar.

Finally, please note that the amounts shown above are pre-tax income amounts. Federal and state income taxes will have a significant effect on your after-tax income, and should be taken into account. The income taxes you pay will vary depending on whether your retirement savings have been invested before taxes in traditional IRA or 401(k) accounts, or have been invested after taxes, such as in a Roth IRA, or are eligible for special tax treatment on capital gains, ordinary dividends or municipal bonds.

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