Investments for Retirement Income: What Are the Best Options?

When you stop working, you still need money to pay expenses and have fun.  You might get income from Social Security or pensions, but you typically need more, which you draw from retirement savings.

So, how exactly do you turn your nest egg into income, and what are the best investments for income in retirement? You’ve got several options, and we’ll cover all of this (and more) below.

Key Takeaways:

  • Living off the interest is difficult for most, as it requires significant assets to produce a meaningful income.
  • Being open to spending down is ideal, although your savings might actually grow over time.
  • Flexible income strategies like guardrails could allow you to start with a higher income, but you need to be willing to adjust.
  • Dividend investing strategies can bring risks that retirees may not be willing to accept.
  • Income annuities offer simplicity and guarantees, but be mindful of inflation and what happens at death.

Ultimately, you need to make several decisions as you transition from saving money to spending money, including:

  1. Where to invest money in retirement
  2. How to structure your spending each year (how much to spend)

Continue reading below, or get similar information from this video.

Can You Live off the Interest?

People often wonder if you can “live off the interest” during retirement. The goal is to avoid spending any of the money you saved and invested over the years, and instead spend only your interest earnings or dividends. The result is a safety net for surprises or an inheritance for loved ones.

In the past, your parents or grandparents might have pulled this off. Interest rates were at double-digit levels, enabling retirees to buy FDIC-insured bank products and government bonds that paid high rates.

However, it’s important to understand the big picture.

First, remember that high interest rates typically come with high inflation. So, those rates might not have been as generous as they seem—at least not initially. That said, if you bought a 30-year Treasury bond while rates were at their highest, things likely went well after inflation cooled and rates fell.

Next, the question becomes how feasible it is to live off the interest with today’s interest rates.

Example: Assume you can get 5% per year in a safe bond or a bank CD. How much money would you need to invest to support your spending?

Answer: To arrive at the principal needed, divide your spending amount by the interest rate.

Let’s say you want to spend $60,000 per year from your investments (ignoring Social Security). To determine the amount of money needed, divide $60,000 by .05 for a result of $1,200,000.

With $1.2 million earning 5%, you’d get income of $60,000 per year. But this ignores taxes, which are a reality. So, you might need more than $60,000 of interest (and therefore more money saved) to cover the taxes.

Dividend investing: This is the same approach you’d use to calculate how much you’d need in dividend-paying stocks to provide a given level of income. We’ll talk more about dividends later, as those investments are more complicated.

Critical questions:

  • Can you save $1.2 million?
  • How will you keep up with inflation if your interest rate stays the same (prices will likely rise, but your income remains the same)?
  • What if interest rates fall and your income drops?

Unfortunately, counting on a specific income from interest alone can be risky. To lower your risk, you’d need to accumulate more. That might require that you work longer or spend less during your working years. Both of those options could feel like a burden, and it might not be necessary to go that route.

If you’re open to spending down assets over time, things may look better.

Spending Down

A simplified retirement income investment strategy is to build a portfolio with an acceptable level of risk and spend down assets over time. You might include a cash buffer to provide a safe haven during market crashes.

To be more precise, you might just need to be open to the idea of spending down your assets. In some cases, people end up withdrawing less than they earn from their investments. As a result, they die with more money than they started with.

This is often known as total return investing, and the strategy might involve a diversified mix of stocks and bonds. The idea is to pursue both income and long-term growth (or capital appreciation and gains) in your investments.

It’s relatively easy to build a portfolio with index funds or ETFs, and you don’t need to overcomplicate things.

A super-simplified example of an investment approach is something like a four-fund portfolio of index funds.

The exact level of risk will depend on your appetite for risk and how much you’re withdrawing each year. You can keep things relatively safe, or you can go for more risk if you’re okay with potential losses. Just remember that you might or might not have time to recover from those losses before you need to spend money.

Pros and Cons of Total Return

Familiarity: An advantage of this approach is that you’re probably already familiar with this investment approach. As a result, you don’t need to wander into uncharted territory at a time when the stakes are highest.

Capital gains: You also don’t need to sell everything and switch to different investments. If you have assets in taxable accounts, doing so would potentially cause you to realize large capital gains, which could cause problems. If you stick with what you have (and make some adjustments) the tax impact may be reduced.

Inflation protection: If you have an allocation to stocks, those investments can potentially help to offset inflation over the long term. You’ll live through ups and downs, but if all goes well (there’s no guarantee, of course), you’ll ideally come out ahead.

Diversification: A typical diversified portfolio has exposure to different areas of the markets. As a result, there’s less likelihood that you have everything in the wrong place at the wrong time—and you might have a little bit of money in the right place at the right time. Bonds in your portfolio can provide some income and they might reduce the volatility from stocks. All that said, diversification doesn’t eliminate the risk of loss.

Risk: Whenever you invest in stocks, bonds, and other financial assets, there’s a risk of losing money. Historically, markets have mostly risen, but there’s no guarantee that the future will look like the past. You might need your money before your investments recover, forcing you to sell at a loss (which can have severe negative consequences and cause you to run out of money early).

Uncertainty: You don’t know how long your money will last or how markets will perform. It’s possible that your account balance will go to zero.

Critics of a total return investment strategy might argue that investing for income in retirement is different from investing for accumulation. But you might not need a complete overhaul. As long as you have a reasonable amount of risk and you withdraw a reasonable amount, this can be a viable strategy.

How Much Can You Spend?

You’re using investments for income in retirement, but how much can you draw from those investments? That’s a hard question, as you don’t know how long you’ll live or what will happen.

So-called “safe” withdrawal rates get a lot of attention in retirement planning. They aim to tell you how much you can spend from a portfolio without running out of money over your remaining years.

There’s no way to know, but researchers have attempted to answer the question. Bill Bengen’s notorious “4% Rule” aimed to do that, and others have refined things.

While withdrawal rates are far from perfect, it’s still helpful to know how they work. For example, if you’re withdrawing 1% or 2%, you might ask why? Are you being especially conservative or trying to pass assets on to others, for example. Or if you’re withdrawing 8%, 10%, or more, we’d also ask why? Perhaps it’s reasonable to do so temporarily, like in the years before Social Security begins (and you’ll subsequently switch to a much lower rate).

As the name suggests, the traditional rule of thumb says you can start spending at a rate of 4% and expect the money to last for life. Some details about the research finding include:

  • Assume a 50/50 portfolio of stocks and bonds.
  • The goal is for your money to last 30 years.
  • You adjust (or increase) withdrawals every year for inflation.
  • In many cases, you ended up with money left over (4% was the worst-case) scenario.

Since the original research, Bengen and others have arrived at different “safe” rates based on current market conditions and different portfolio strategies.

Ultimately, nobody knows what rate is right. But you can make educated guesses, and you can improve your chances if you anticipate the need for changes. Being willing and able to adapt goes a long way.

Bucketing for Income

To attempt to address uncertainty, some people separate investments into segments or “buckets.”

Here’s how to invest for income in retirement with buckets:

  • Short term: One bucket holds money you intend to spend soon, such as within the next one to three years. You want that money to be there when you need it, so you typically keep funds in cash and similar investments that are liquid and safe.
  • Long term: Another bucket is money you won’t touch for at least 10 years. You may  want that money to grow over the long term, so you might invest with more exposure to stocks. Ideally (no guarantees, of course), the money should grow or hopefully maintain value over 10 years.
  • Medium term: You might have one or more buckets in between those two extremes. The more buckets you have, the more complicated things get—and the more difficult it becomes to manage your buckets year-by-year. But some people enjoy having everything planned out.

When you need income, you withdraw from the short-term bucket. Over time, you’ll deplete that bucket unless you refill it from longer-term buckets.

Medium term buckets might hold a mixture of stocks and bonds, or they might include investments that pay interest and can replenish the short-term bucket.

To learn more about this income strategy, read about bucketing.

Retirement Income Guardrails

Being flexible with your spending can improve your chances of success. In fact, most people do this on their own. When they see markets crashing, they might tighten the belt a little. And when things are going well, they feel more confident about spending money.

One framework for managing retirement income is with “guardrails” that tell you when to reduce spending (or better yet, when to spend more).

With guardrails, you identify asset levels that will trigger a change in spending. For instance, a guardrail strategy might look as follows:

  • You have $1,000,000 in assets.
  • You plan to withdraw roughly $4,000 per month before taxes.
  • If your accounts lose value and fall to $651,000, you hit a guardrail.
  • You reduce spending to $3,828 per month (before taxes) until accounts recover or you hit another guardrail.

Example of retirement income spending with guardrails

As a bonus, you might be able to start with a higher withdrawal rate if you use guardrails. When compared to a static “safe” withdrawal rate like the 4% guideline, a guardrails approach generally allows you to pay yourself more. But you need to be willing and able to adjust (or reduce) spending if needed.

Of course, things could also go well. So, if your account balances continue to rise, you can eventually increase spending. You might add an extra $201 per month to your budget in this example.

There is some art and science in picking the right amount to start with.

Naturally, the more you spend initially, the more likely it is that you’ll need to make adjustments. Whatever level you start at, it’s critical to understand that changes may be necessary if your investments lose value. If that’s not going to work, then guardrails might not be the right income strategy for your household.

As far as investments, a guardrails strategy often assumes you use a total return portfolio as described above.

To implement a guardrails strategy, you can use software or basic rules.

Monte Carlo Analysis

One way to evaluate your odds of success is a Monte Carlo analysis.

With that approach, you randomize the sequence of returns you might expect from a given portfolio. Portfolios with more money in stocks tend to have a wider spread of potential outcomes, and more conservative portfolios have a more narrow spread. Then, you see how often your money lasts under specific assumptions.

Monte Carlo is a decent way to plan for retirement income with detailed inputs. You can plan every expense, project tax costs, test different strategies, and explore optimistic and pessimistic outcomes.

The primary measurement of a Monte Carlo analysis is whether or not you have enough money to provide income in any year. If you run out of money, income from your investments stops, and the plan is deemed a failure.

While this analysis can be enlightening, there are several pitfalls to be aware of.

No adjustments: Unlike a guardrail approach, Monte Carlo analysis often assumes you’ll spend your accounts down to zero. But most people will see problems brewing with their investments and reduce their income.

No guidance: Monte Carlo can tell you how likely you are to succeed with the assumptions used, but it doesn’t tell you what to do about it. Contrast that with a guardrails approach, which tells you exactly how much to adjust your income if things are going badly. That said, you can manually change some assumptions and check on the results.

What is “failure”? Monte Carlo assumes that your plan is a complete failure for any year when you run out of money before death. But the reality is that you might still have income coming from Social Security, pensions, or other sources. So, while running out is almost certainly bad, it isn’t necessarily catastrophic.

Unrealistic scenarios: Because the investment returns are randomized, you might end up with unrealistic outcomes. For example, if you get the worst possible year in Year 1, followed by the next worst possible year in Year 2, and you continue getting the worst possible outcomes, that might not be realistic. It’s possible that there would be a reversion to the mean at some point.

What About Dividend Investments for Retirement Income?

Retirees often gravitate toward dividend investing strategies, as those investments seem to provide a steady stream of income.

For example, if you wanted to spend roughly 4% of your nest egg and you invest in securities that pay 4% or more, you could potentially “live off the earnings.” As with living off the interest of bank products, this approach has some pitfalls and risks.

Dividend investors argue that their income continues, regardless of how a stock performs. So, even if a stock’s price falls, they expect dividend payments to remain the same (or grow). An analogy is that if real estate prices fall, your renters continue paying the same rent. Plus, your kitchen and bathroom don’t shrink when your home loses value, so what’s the problem?

That is indeed the way things work out—sometimes.

But dividend investing has unique risks that retirees need to consider.

Diversification? Dividend strategies tend to narrow your investing lens. You end up excluding certain parts of the markets, as your primary criteria for picking investments is the dividend yield. As a result, you might miss out on growth in other areas. Perhaps more importantly, you might experience outsized losses if the areas you invest in face headwinds.

Dividend cuts: Companies can cut dividends. You might not think it’s likely, or you might think you can choose higher-quality companies, but it’s still possible. There are plenty of examples of household names that reliably paid handsome dividends—until they didn’t. And when a company cuts the dividend, you can expect the stock price to be lower, as well.

Volatility: If you truly don’t care about the value of your assets and if you never experience a dividend cut, things might work out fine. But those are some bold assumptions. It’s possible that your view of risk will change in future years, or you might need to take large withdrawals for unexpected expenses. If that happens at a bad time, things could go badly.

Remember that you probably already get dividends out of a traditional total return portfolio. The yield might be lower than a dividend-only strategy, but you’re probably more diversified. We can’t say what the best strategy will be in advance, but the textbooks generally promote diversified investing strategies over narrowly focused strategies.

Vanguard published an education piece on this topic, coming down squarely in the camp of traditional diversification: “Total-return investing: A superior approach for income investors.” Again, that doesn’t mean total return will always come out ahead—but you’d want to have good reasons for diverging from that path.

Dividend investing might also involve buying individual stocks. While there are ETFs and mutual funds focused on dividend income, some people prefer to pick specific companies. That adds additional risks, as you’ve got your eggs in fewer baskets. If you go that route, it’s critical to know everything about the company (including what’s happening with customers, suppliers, competitors, management, and more) and continually monitor your investment.

Keep in mind that even dividend-focused funds might have a limited number of holdings relative to an S&P 500 fund.

Finally, remember that there’s no free lunch. Stocks with high dividends often have a story behind them. Investors generally demand higher returns when taking bigger risks, so an unusually high dividend might point toward higher risks.

All that said, I can’t claim that dividend investing is wrong or that you shouldn’t do it. It’s possible that things will go well, but it’s not my preferred strategy for income investing in retirement.

Annuities for Income

While annuities are problematic, they can do one thing well: pay retirement income for life.

Most clients prefer to avoid annuities, as the insurance industry has not earned the best reputation with high commissions and one-size-fits-all sales practices. But insurance products, when used properly, offer unique features that aren’t available in other vehicles.

Guarantees: The primary reasons to consider annuities are the guarantees available. If you don’t want or value those guarantees, the products don’t make sense. But if you want an insurance company to ensure that you have income for life—regardless of how long that is, and including the life of a spouse or beneficiary—annuities might make sense.

Simplicity: If you just want somebody to pay you for life, an annuity might do the trick. For example, you hand over money, and you get monthly income in your bank account. That way, your retirement income is similar to income during your working years, and you don’t need to choose and manage investments as you age.

Mortality credits: While the mechanics of annuities are complicated, it’s worth knowing that you can potentially benefit from these products if you live a long life. On the other hand, if you die early, your money will help others (which you might or might not care about).

All that said, annuities have their pitfalls.

Complications: The simplest annuities, known as single-premium immediate annuities (SPIAs) pay income as described above. But the term “annuity” can include other products with numerous bells, whistles, options, and costs. The more complicated something gets, the easier it is to misuse.

After death: The main challenge people have with annuities is the question of what happens to their money at death. If you choose the highest income (which would make sense), you and your beneficiaries typically get nothing after death. But there are alternatives. For example, you can name somebody to continue receiving income for life or for a specific period, or a beneficiary might get a lump sum. However, those beneficiary options typically lead to a smaller monthly payment and don’t maximize the power of annuities.

Inflation: Most annuities currently available do not link directly to inflation. You might find products that increase your income at a set rate, but that rate might or might not keep up with actual inflation.

There are additional pros and cons of using annuities as income-producing investments in retirement. Be sure to speak with objective experts—not just somebody selling annuities—and review the tax implications with a tax expert. That’s especially important if you’ll use taxable accounts to fund a nonqualified annuity.

Remember that annuity guarantees are only as strong as the insurance company you work with. It’s safest to stick to companies with the strongest financials and the best reputation, but even the good ones can fail.

Taxes on Retirement Income

How is investment income taxed in retirement? It depends on the source of income.

Money from pre-tax accounts such as a deductible IRA or pre-tax 401(k) is generally treated as ordinary income. That’s the same treatment as earnings from work, especially for federal income tax. Some states exclude various sources of retirement income from state income tax calculations.

Money from Roth-type accounts can potentially come out tax free. But you need to satisfy IRS requirements for this treatment, which generally means reaching age 59.5 and having a Roth account open for at least five years. But there are some exceptions to this rule most other rules.

So, how much will you pay in tax? You need to look at all of your income sources (remember that some of your Social Security income might be included in your taxable income) and estimate what your tax rate will be in retirement.

Asset Location

Whatever approach you take, pay attention to where you keep various assets. You’re probably familiar with asset allocation (or the amount of stocks vs. bonds vs. cash). But once you have that settled, consider “asset location,” as well.

This concept can be as complicated as you want. The basic idea is to put assets with the most (expected) growth in Roth-type accounts and assets with the least growth in pre-tax accounts. By doing so, all of that growth can potentially come out of the Roth tax-free. Meanwhile, you can possibly avoid causing your pre-tax accounts to grow to the largest levels—eventually causing taxable income in retirement.

Other Ways to Invest

We’ve covered some of the most straightforward approaches so far, but there are other options. For example, you can invest in real estate or any other strategy that might provide income. The key is to understand the mechanics, risks, and benefits—and then decide what’s best for your retirement.