For a long time, I’ve dreamed about someday amassing, say, $1,000,000, and just living off the interest (at 5%, I can get $50,000 a year, which is significantly above the average yearly American income). What are the complexities involved in this? Is it a sustainable way to earn money over the long-term? How much would I have to pay in taxes yearly, assuming that I don’t make any other money than what I earn in interest? Would taxes eventually erode my $1,000,000 savings?
I don’t know about significantly above the average – I believe American incomes currently average around $45,000. And this plan doesn’t take inflation into account.
But what you describe is basically an annuity. With a deferred annuity plan, you can accumulate assets tax-free in the annuity account until some point at which the annuity begins paying you a fixed sum until you die. The amount withdrawn each year is taxed.
What if you take the million bucks and buy Treasury bills or bonds? Wouldn’t the interest be tax free? At a 5% rate, you could clear $50K a year and never touch the principal.
Financial host Bob Brinker suggests holding a “balanced” account. Using his example you’d hold 50% in stocks (like the total stock market index) and 50% in high quality fixed income (say, a GNMA fund and a short term bond with a little inflation protection fund thrown in).
From this he reccommends taking out 4% a year. BTW, he’s not alone in that 4% number. Financial writers like Jane Bryant Quinn and Larry E. Swedroe seem to like that 4% withdrawal number, too.
A couple of things are in play here…over the long haul(according to the above mentioned writers) you should earn more than 4%, so you’ve built in protection of prinicpal. In addition the long-term growth of equities and the reinvested interest not taken builds in inflation protection.
Leaving aside everything else, though, the bigger issue is cost of living. Sure, right now your 5% interest and $50,000 gives you a nice lifestyle (assuming, of course, that you either are living in or have moved to one of the cheaper areas of the world to live in). But as the cost of living goes up – you’re paying more in rent, or for gas and food, or your insurance premium doubles, etc. – you’ll end up dipping into the principal to make ends meet. Consider the difference between what $50K buys today versus twenty years ago.
Your question about income tax is the same issue. If you’re living off the interest, but dipping into principal to pay taxes, you’re decreasing the amount on which you’re earning interest.
Some people can chart out a way that you can estimate how long you think you’ll live, and work out how to nibble away at the principal so that by the end of your life, you have gone through almost all of your money (the theory being that you won’t need it after you die). But you do have to take cost of living into account, and you also need to consider what your catastrophic plan is (what happens if you need a caregiver, for example?).
So you’re better off doing as others suggest – developing a balanced portfolio with some flexibility as time goes on.
Sure you can do this. The interest is taxed as ordinary income, unless it came from a tax-advantaged source like a Roth IRA or muni bonds. The main risk to such a strategy is inflation. Having a fixed income with rising costs will force you to dig into the principal or to alter your standard of living. Actually, the biggest obstacle in your strategy is the first part. You have to first amass $1M to fund your annuity. And, of course, whereas $1M will work for you, others will need a larger principal to maintain their standard of living. $1M won’t hack it for me 
. Good luck in reaching your personal critical mass.
What are interest rates like in the US just now? Is 5% a reasonable expectation? It seems low to me, you can get 4% on a current account over here just now. With $1m surely there are ways and means (still low risk) of getting more like 10% no?
If you invest $100,000 at a time, you can get a “jumbo” Certificate of Deposit which pays a better rate. Currently, you won’t get much more than 5.25% for a year, and the $5,250 that comes out the other end will be taxed.
Bond funds purchase poorly-rated bonds where the borrower is a company, municipality, or state with a less-than-stellar credit rating, and the borrower pays a premium above the going rate – however, bond funds make money by taking on risky investments, and sometimes the borrowers default. A long-term bond fund called DEEAX has averaged 8% over the last five years, and that’s pretty good.
There is no low risk way of getting 10% compounded a year unless you have a crystal ball. It is possible with high risk investments which is why they are considered high risk. You might be able to pull off 7% in medium low risk category using a mix of stocks and bonds.
If you don’t want to touch priincipal then you need to think like this …
I invest 1 million dollars at 5%. I get $50,000 in interest paid to me.
But, if the investment is taxable, Uncle Sam & my state govt will want ~25% of my $50K. And they get theirs before I get mine. So they get $12,500 & I get the remaining $37,500.
But inflation is 3%. So for my principal to be worth the same purchasing power at year end as it was at year start, I need to leave $30,000 in the account & only spend what’s left.
So I get $7,500 a year to live on.
This is how lottery winners go broke.
If you invest in zero or very low risk investments that are taxable, you can only make 1-2% a year after tqaxes & inflation. At that rate it itakes $10million in savings bonds/CDs to just eke out a middle-class income. And it takes $100million to live low-end rich.
I think the OP is talking about interest on savings. He would get the dividend monthly, wouldn’t he? Uncle Sam doesn’t get its percentage before the OP does, and as long as the OP lives within his means, that is not dipping into the principle, leaving the taxable portion in the savings account, and also setting aside a little savings each month (which just means letting part of his dividend stay in the account and rollover into the principle) he should be able to keep up with COL increases, shouldn’t he?