Before the article, here’s what’s happening this week on our podcast, Personal Finance for Long-Term Investors:
Today’s Question
Barry wrote in and asked:
Jesse – I’ll need about $100,000 per year from my portfolio in retirement. I have $3M in my retirement portfolio. It’s producing about $60,000 in income and dividends for me, meaning I only need to sell $40,000 (net of taxes) of the principal value to fund the rest of my need. By my math – $40,000 divided by $3M is about 1.3%. That withdrawal rate is WAY less than the 4% rule.
Am I thinking about this correctly?
Financial Planning Background Info
Before answering today’s question, we must ensure we’re all on the same playing field.
The 4% Rule
If you’re not familiar with the 4% rule, here’s some excellent info for you:
- Some 4% rule basics
- Why many people are using the 4% rule all wrong
- Is the 4% rule too risky?
Where Do Investment Returns Come From?
We also need to discuss where investment returns come from. Where does the “growth” come from if you own stocks, bonds, real estate, or anything else? How does the “return on investment” end up in your pocket?
The answer is different for each investment class.
But *most* investments provide their return to investors via two separate mechanisms:
- They regularly return cash to investors. This could be interest from a bond, a dividend from a stock, or rent from real estate.
- The investment itself appreciates in value. This could be a stock increasing in price over time (as the underlying company grows and becomes more profitable) or a building you own growing in value (due to capital improvements or increased demand in its local market).
For a typical retirement portfolio:
Portfolio Growth = Dividends + Interest + Capital Appreciation
When someone says, “A 60/40 portfolio grows by ~9% per year, on average,” what they are actually saying is:
9% = Average Dividends + Average Interest + Average Capital Appreciation
Do Dividends and Income Count Toward the 4% Annual Withdrawal?
To answer today’s question:
Yes, if dividends and income leave your portfolio, they are part of your withdrawal rate. If you extract 2% of your portfolio via income and dividends and another 1.3% via selling assets, then your withdrawal rate is 3.3%.
The dividends and income are not free money. They are one of the key components of your overall portfolio return. If you weren’t extracting those dollars, you’d reinvest and compound them. Believing that dividends are “free” is one of the biggest misconceptions in DIY investing.
The 4% Rule Is Limited…But *This* Is Much Better
The simple fact is that the 4% rule—or any withdrawal rule—is only a rule of thumb. It’s a starting point but highly limited. You must go deeper.
A real CFP financial planner would use a long-term cash flow model to analyze your portfolio’s planned withdrawal sequence, including any income or dividends from your taxable account.
Your withdrawal sequence is likely to be lumpy. It’ll change once you start collecting Social Security And change again when you hit RMD age. Some years should include Roth conversions. You should plan all of this out ahead of time!
Starting your retirement without taking this detailed step is a risky move. If you haven’t taken it already, there’s no better time than now.
Thank you for reading!
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-Jesse
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Interesting point about not separating income and asset sales when thinking about withdrawal rates. It makes sense — whether I’m paid through dividends or growth, it all impacts my portfolio’s sustainability. Thanks for making that concept so clear!
You’re welcome! Thanks for reading.
Jesse
Interesting question. What I am wondering is if taking the dividends is a good strategy. It would seem that if you have a 60/40 portfolio one would want to take evenly across all assets, or maybe disproportionately from any that are up say more than the market? Assuming you auto reinvest dividends, wouldn’t it be better to reinvest them into lower priced assets? Maybe I’m just rearranging deck chairs, ha!
Hi Paul – interesting question.
“Is taking dividends a good strategy?”
If those dividends are from a Qualified account, we must answer, “Why are we choosing to either realize taxable income (from a tax-deferred account) or withdraw tax-free assets (from a Roth account)?”
There can be good reasons to do so, but you must answer those questions.
If it’s from a taxable account, well, you’re going to pay the taxes on those dividends and income anyway! So now, since the tax consequence is the same, we should ask, “Would I rather have this money in a bank account, ready to spend in the next 12 months? Or reinvest it for longer term growth (hopefully).”
To address the other part of your question:
Yes, I think it’s smart to use the withdrawals you’d be taking anyway as a means to rebalance your portfolio.
e.g. if your 60/40 from January is now 55/45, and you need to make a $10K withdrawal, I would take it from the “45” and therefore get closer to the 60/40 target.