Financial Makeover: Living Off Investments

Nov. 10 -- — Q U E S T I O N: I am considering retiring next August at age 59½. I'd like to live on the interest earned on my IRA and 401(k). I have $516,000 in retirement accounts and will add $16,000 by next August. If I could get an 8 percent return, I could make it. I'm thinking about moving the money into bond accounts or preferred stock. What would you advise?

— Ron

A N S W E R:

Many people are fascinated with the idea of living "off" a portfolio: "I'll build a portfolio during my working years and invest it in bonds when I retire so that I can use the interest income to cover my expenses and preserve the principal." Unless the portfolio size is already significantly larger than what the person needs to cover their financial desires, this strategy is a difficult one to pull off successfully. Here are some factors that Ron should keep in mind:

Spending Levels

Ron estimates that if his retirement accounts generate income equal to 8 percent of the total retirement account balances each year, they'll throw off enough interest and dividends to cover Ron's living expenses for the remainder his life. Theoretically, Ron wouldn't touch any of the principal, and it would, therefore, be available for some unidentified reason at Ron's death. My concern is whether the 8 percent income return is an accurate calculation of Ron's annual needs.

Ron's current salary is $112,000 per year. After 401(k) contributions, $97,000 of his 2003 pay is subject to tax. Assuming a 30 percent average federal and state income tax rate and no other sources of income, Ron generated about $69,000 of after-tax earnings this year.

On the other hand, Ron's combined 401(k) and IRA balance, after considering 401(k) contributions he makes before retiring, is $532,000. An 8 percent annual income return means Ron would take annual pre-tax distributions of about $43,000 from the accounts.

Assuming a 10 percent average combined income tax rate (this rate is lower that the average tax rate I used above because Ron's taxable income is much lower and is, therefore, not exposed to the higher marginal tax brackets), Ron would have about $39,000 after taxes to spend each year. This is 43 percent less than Ron's current after-tax salary!