What Is Investment Income?

There’s no free lunch. When placing your money with a company, whether in the form of ownership (stock) or as a lender (bond), you’re going to expect a form of compensation. That compensation can take the form of:

  • Appreciation (and potentially depreciation) of your investment
  • Investment income from that investment. 

The combination of the two (appreciation and income) constitute an investors total return. More on that later.

The scope of this article is to shed light on utilizing investment income within the scope of retirement. We’ll take a quick glance at its historical use as well as an example of how to put this to work in a modern perspective.

The Past: It was all so simple then.

Back in the day, creating and potentially living off your investment income was relatively easy and simple:

  • First, you’d figure out what you needed to live on. 
  • Subtract sources of income (work, Social Security, pensions, etc).
  • Take the difference and divide by the amount you have invested.

For example, if you needed $60,000 per year for living expenses and your sources of income totaled to $40,000, basic math will tell you that your investments need to produce $20,000 in investment income.

Assuming that the average bond and/or stock yielded 5% in annual income (bonds pay interest, stocks pay dividends), you can easily back into the amount you’d need to have invested: $400,000.

The Present: A challenging environment for the income investor. 

This worked great back when interest rates were “normal.” However, since the global financial crisis this has not been the case. With interest rates at record lows, an investor in need of investment income would need to either:

  1. Have a large amount invested.
  2. Drastically reduce their spending lifestyle. 
  3. Look at other sources of income.
  4. Increase their allocation to stocks, potentially adding to risk.

Note: There are other viable sources of income that can help compensate for the low interest rate environment: real estate, part time work/consulting, and alternative asset classes (not a stock or a bond) and so forth. 

You may even find a stock or bond that pays an unusually high amount of dividend/interest. However, be cautious: an instrument paying more than the “market rate” may very well be compensating an investor for an increased level of risk. 

The Future: Piecing income together.

While the past 10+ years haven’t given much in the way of traditional income, what it has provided is an expansive amount of growth. Going back to the earlier statement on total return, according to popular blog site Don’t Quit Your Day Job:

“The S&P 500 Price index returned 26.61% in 2021. Using a better calculation which includes dividend reinvestment, the S&P 500 returned 28.41%.”

Let’s use this snapshot as an example. Viewing the chart below, you can see that even though the index didn’t provide much traditional “income” – it did provide a fair amount of growth. Ditto for the past 10+ years. 

S&P500 Total Return 2021

The natural question becomes, how can we use this growth to fuel our income? What’s the impact?

The long and short of it is this: in order to use growth to supplement your income you’ll need to sell some of your appreciated assets. Rinse and repeat for every year you need the supplemental income. 

Using the illustration above and assuming your investments needed to generate 5% in “income,” it’s fairly easy to see that you can withdraw (sell) the 5% you need and reinvest the difference – in this case, 23.41%. See the example below:

5% Withdrawal

However, one of the unique benefits in doing so is the potential for lower taxation on that “income.” More specifically, if you sell appreciated assets you’ve held for longer than one year, your long term capital gains rate may be lower than your marginal tax bracket. 

This assumes that your dividends and interest are all taxable at ordinary income levels (not the case with qualified dividends or tax free bonds). A quick comparison can be seen below:

LTCG Bracket

All in all, the investment landscape is ever changing and adaptability is key. Thankfully, the past decade has provided a decent amount of return to help compensate for lower interest rates. 

It’s also important to keep in mind that the opposite is also true: it’s possible to NOT have high amounts of growth while still incurring low interest rates. At any rate, that’s when mindful financial planning comes in handy. 

Sources: https://dqydj.com/2021-sp-500-return/