Saving up a nest egg of money to spend during retirement years is a strategy used by many. One of the great things about investment accounts is they usually earn interest, so they grow over time.
But is it possible to leave the nest egg invested and live off only the interest income it produces? Perhaps, even, to retire early and live off of interest? The answer is yes, it is possible, but it is not as easy to achieve as it may seem.
Retirement planning has gotten more challenging and complex in recent years since Social Security funding is less secure, long-term stable income is harder to come by, and people are living longer. And successfully living off of investment income requires careful planning and diligence.
Let’s explore the strategies and challenges involved in living off investment interest.
How Much Money Would It Take to Live off of Interest?
Everyone has different needs and goals when it comes to retirement lifestyle. The size of nest egg required depends on an investor’s target income and interest rates.
$1 million is often cited as the magic number for retirement. Let’s break down a few possibilities for investors who have $1 million in savings. (All scenarios below are hypothetical).
In a savings account that earns 1%, that would come out to $20,000 of interest income every year.
Invested in bonds earning 2.87%, $1 million would generate $28,700 in interest each year.
$1 million might seem like a lot, but it’s actually achievable. Especially because of the magic of compound interest. Compound interest is the addition of interest to an initial investment.
Rather than just earning simple interest on the initial money an investor saves, they also earn interest on the interest.
Here’s an example. If an investor saves $550 each month and puts it into their investment portfolio, that’s $6,600 a year.
Let’s say their investments earn 6% interest annually. After 40 years of investing and accounting for compound interest, the investor would have $1,021,428.97.
Of course, saving $550 every month isn’t feasible for everyone.
Investors can use this handy calculator to make estimations of earnings based on their savings abilities and including compound interest.
However, it’s not quite that simple.
The Principal Principle
In order for an interest-only retirement plan to work, an investor must stick to the rule of only spending the interest. The invested money that’s earning interest is called principal. The principal can’t ever be spent, as it needs to remain invested to keep earning interest. This is known as the principal principle.
A declining amount of invested principal results in a declining amount of interest income. If an investor doesn’t stick to the principle and they take out some money from the principal, it may be difficult to keep maintaining their current lifestyle. That may result in them taking more out from the principal, and so on.
Making Interest Only Work
In addition to sticking with the principal principle, there are a few other key strategies people use to successfully live off of investment interest.
One of the most important strategies investors use is living below their means. If someone makes $60,000 a year on interest, but they only spend $54,000 a year on living expenses, that leaves them with extra money in case of emergencies and unforeseen expenses, or they can choose to invest the money and increase the principal amount.
Making a strategic plan early in life might be the best way to achieve financial retirement goals. One good way to start making a plan is by working backward starting with the desired amount of monthly income based on expenses and lifestyle goals.
Here are a few other figures and facts to keep in mind:
• Investors should factor in any raises they predict they will get at work each year.
• The long-term historical growth rate of the S&P 500 is around 8%.
• Human life expectancy is higher than ever. Investors should plan to live into their 80s, 90s, and even 100s. If retiring at age 65 or even younger, cash flow may need to last for multiple decades.
• Expenses may increase as investors age due to medical needs.
• Investors should factor in changes in tax rates, income taxes, capital gains, and other relevant payments.
• Most Americans pay into Social Security, but the amount they will receive depends on their date of birth and income. Investors can estimate their Social Security earnings by visiting the SSA website.
A Few Notes on Retirement Saving
Beyond having financial goals and a plan, there are a few ways investors can make saving money easier.
Setting up Automatic Savings
By sticking with a consistent savings amount each month and setting up accounts to automatically put that money aside, investors might not notice that it’s gone and could be less tempted to use that money for something else.
If the savings amount is a percentage of salary, investors could increase that monthly amount as their salary increases over the years. Before they know it, investors will have a significant amount of money saved up and earning interest.
Avoiding Lifestyle Creep
If investors consistently live below their means, they might have money left over to put into savings. It can be easy for people to start spending more on food, travel, housing, clothes, and other items as their salary and savings accounts increase. By avoiding lifestyle creep, investors can more easily reach their goal of an interest-only retirement.
People often think that their expenses will go down when they retire, because they won’t have to buy work clothes, pay for gas to commute, buy lunches, and other day-to-day costs.
However, retirement costs, like travel and leisure, as well as medical expenses, can add up quickly. Investors should expect to spend 70% to 90% of their pre-retirement expenses during their retirement years.
Keeping a Long-Term Mindset
One smart solution is to stick with low-risk, long-term investments when it comes to retirement accounts.
Buying and holding helps investors avoid short-term capital gains taxes and risks. By saving up small amounts over a long period of time, and earning compound interest, living off of interest is possible.
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Building an Interest Earning Portfolio
Once an investor knows what their goals are for retirement and how much they are able to save each month, they can start to explore investment options. Long-term, safe investments tend to have lower yields than riskier investments, but they are more secure and consistent.
It’s important to keep in mind that even “safe” investments come with risks. Investors might want to decide what the right balance of risk is for them and what return on investment they are looking for.
Diversification is key to building a successful portfolio. By spreading out money into different types of investments, investors could reduce risk and maximize earnings.
The most common type of interest-earning investment for retirement portfolios is bonds. These can be treasury, agency, corporate, or foreign treasury bonds.
Each type of bond will come with its own risks, such as price fluctuations, changes in the market, and the possibility of default. One strategy investors use to avoid some of these risks is called laddering. This is when investors buy bonds with varying maturities.
Maturity is the date on which the life of a bond ends. At the maturity date, the borrower must pay back the principal to the investor, or the bond may be renewed.
Diversifying amongst different types of bonds is a good idea when building a portfolio. It’s also important to pay attention to changes in interest rates, both for bonds and other types of investment.
Some investors choose to invest in mutual funds, which are made up of money pooled from multiple investors. The pool of money is invested into bonds, stocks, and other assets, which are chosen and managed by professional money managers.
Although mutual funds can pay out earnings and interest, they aren’t as consistent or predictable as bonds.
The funds are made up of multiple assets that can all change over time. If an investor is trying to keep their principal invested and only lives off of interest, but the amount of interest they earn fluctuates significantly from year to year, this may not work.
Fixed Deferred Annuities
Another type of interest-earning investment is called a fixed deferred annuity. Similar to a certificate of deposit, a deferred annuity is a contract with an insurance company.
The contract states that the company will pay the owner a lump sum of money at a future date. Deferred annuities can be good investments because they are low risk and tend to pay out higher interest rates than treasuries or certificates of deposit.
The Challenge of Inflation
Unfortunately, living off of interest isn’t quite as simple as it seems. This is due to inflation, which devalues the dollar by about 3% each year. Inflation is the rate at which the purchasing value of money goes down as the prices of goods go up.
What this means is that although the amount of interest earned each year might stay the same, the amount of goods and services that can be purchased with that amount goes down.
Investors can estimate and plan for inflation as they create their retirement goals and plans, but it means they might have to save up quite a bit more and keep their monthly expenses down in order to avoid violating the principal principle.
The only type of investment that protects against inflation are TIPS, or Treasury inflation-protected securities. TIPS are treasury bonds that rise in value as inflation rises.
TIPS – Treasury Inflation-Protected Securities
U.S. Government-issued TIPS have maturities of five, 10, or 30 years. They pay out interest every six months, and the amount paid goes up as inflation rises.
TIPS are purchased in $100 increments directly from the government, or through ETFs (exchange-traded funds) or mutual funds.
Pursuing an Interest in Interest
Living off interest depends on a number of factors, including monthly savings, investment choices, and lifestyle needs. Determining goals and realistic monthly savings amounts is the first step. If investors do their homework to figure out how to live off interest successfully, it could be achievable.
Once investors have a plan, they can start building a strong, diversified portfolio. A great way to start doing this is by using an online investing tool.
SoFi® offers a full suite of investing tools right at your fingertips. Using SoFi Invest®, you can hand-select stocks and assets through Active Investing, or invest in pre-selected groups of stocks using Automated Investing.
Consulting with a SoFi financial planner could also help you achieve your investing and retirement goals.
SoFi has a team of professional financial planners available at no cost to help you get started and answer your questions.
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