Living off of portfolio income can be trickier than most people realize. Historically, many financial planners advised their clients that they could have a reasonable expectation of living on a balanced investment portfolio by withdrawing 4 percent per year. The sudden market downturn of 2008, however, coupled with low interest rates on bonds, made that approach very dangerous, as investors either had to increase the spend-down rate or take a crippling decrease in portfolio income.
Consider annuities. Annuities are savings and investment vehicles specifically designed to generate an income for the annuitant for a specific period of time, for life, or for the combined lifetimes of an annuitant and a spouse or other designated beneficiary. Only insurance companies sell annuities. If you elect a lifetime payout, the payout is guaranteed by the general fund of the insurance company. So even if your annuity balance reaches zero, the insurance company will still make the promised income payments. If you try to do the same thing with a mutual fund, stock or bond portfolio and you spend all your money, your income will cease.
Cut your expenses. You should understand that if you try to pull too much income out of a portfolio of stocks, bonds or funds, you also increase your risks. For example, a AA-rated corporate bond may generate an income of 5 percent per year, while a B-rated bond generates an income of 9 percent. But the risks of default are higher with the B-bond issuer. That is why it must pay 9 percent to attract capital. You must keep your expenses down to avoid spending down your portfolio too fast or being forced into riskier investments, risking disaster in an attempt to keep up with your spending.
Use bonds. Bonds are debt obligations. The bond issuer has, in effect, borrowed money from the bondholder, and pays regular interest payments to the bondholder in exchange for the use of the investor's money. Typically, the bond issuer will make an interest payment every six months, until the bond matures, which can be years and even decades in the future. As long as the company does not default, you will receive your money in a steady, predictable stream of income. However, there is a risk that the issuer will pay off the bond early, forcing you to reinvest the money at lower, less advantageous interest rates.
Consider municipal bonds. Bond income is generally taxable as ordinary income in the United States. However, interest from most municipal and state bonds is exempt from federal income tax. This means that your after-tax income from a portfolio of municipal bonds can be higher than a comparable portfolio of Treasurys or corporate bonds. These are more appropriate for investors in higher tax brackets.
Spend down IRA and 401k assets first. You must begin taking distributions from these accounts the year in which you turn age 70 1/2. If you don't take the required income, you will pay a penalty to the IRS of 50 percent of the amount you should have taken out of the account but didn't.
Spend tax-free assets last. Tax-free assets include Roth IRA accounts, designated Roth accounts in 401k plans and the cash value of permanent life insurance. By spending these assets down only after you have exhausted taxable and tax-deferred assets, you maximize the amount of time your tax-free assets can grow tax-free.
- Don't forget about inflation. If you invest solely for income, there is a chance your income will be slowly eroded by the falling purchasing value of the dollar. To hedge against this, devote a portion of your portfolio to growth, or buy Treasury Inflation-Protected Securities, or TIPS, which pay out higher incomes if inflation heats up.
- You can also boost your income by taking a reverse mortgage on your home, if you qualify and are over the age of 62. However, there can be serious drawbacks to this decision -- particularly for your heirs. Upon your death, your estate or your heirs must pay back the reverse mortgage company or give up the home.
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