Investment Income

Managing your investments is a complex topic and is covered in more detail in another BBRC article on Investments.   In this section we review how much you can reasonably withdraw from your investments--a topic that has been, and will remain, a highly debated topic among financial professionals.

The general consensus among investment advisers is that if you wish to preserve the purchasing power of your invested assets, in retirement it is reasonable to spend four percent of your investments each year.   Four percent should be less than the total average return on your portfolio, so your investments should grow and keep up with inflation.  For example, if your portfolio earns seven percent and you withdraw four, your portfolio will have grown by three percent, a figure that many take as the average rate of annual inflation.

OK, but where should that four percent come from?  From taxable or non-taxable accounts?  Should you only tap dividends and interest income, or should you harvest capital gains?  The conventional answer is: tap your taxable accounts first and leave as much as you can in your retirement accounts to accumulate tax-free.  And take interest income and dividends because they are more predictable, and don't require decisions on which stocks to sell.  But whoa!  There is an inconsistency here.  If you own growth stocks that pay little or no dividends as well as high-yielding stocks and bonds, the securities paying interest and dividends should be in your qualified accounts where the income avoids taxation.  Your growth stocks, likely to produce capital gains, should be in your regular accounts. (Currently the tax rate on dividends is unusually low, but historically dividends are taxed at a higher rate than capital gains.)  And here's another reason growth stocks should not be in qualified accounts: when you withdraw money from a retirement account, you pay tax at ordinary income rates.  So if you have $10,000 in a growth stock in an IRA and it shoots up to $15,000 but you then withdraw that $15,000 next year, you will pay ordinary income on the whole $15,000.  If that $10,000 was in a regular account, you would only pay a capital gain tax on the $5000 gain.

The above calculations basically say that when you need cash and income, it's perfectly acceptable to sell some stock rather than insist on only taking dividends and income that have accumulated in your accounts.  What's more important is that you keep a diversified portfolio balanced appropriately between risky and less risky investments, and that you are pursuing a tax-efficient strategy.
Finally, one other caveat about winding down assets in regular accounts before tapping retirement accounts.  Money in regular accounts can be spent anyway you want without tax consequences, like for a down payment on a house or college tuition.  Money in a retirement account, on the other hand, is more restricted in its use, although some clever ways to buy real estate have been discovered.

So keep in mind that if you have spent all the money in your regular accounts, and need a large sum which you have to withdraw from a retirement account, you may have to pay a nasty tax bill.  Assets in a retirement account often go into an account tax-free and always grow tax-free, but they are expensive tax-wise when you need to withdraw and spend them.  Assets in a regular account, on the other hand, go into the account after taxes have been paid, and are subject to taxes on income as time goes by, but there is no tax due when you spend the money.