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When to tap principal in retirement

By Dr. Don Taylor · Bankrate.com
Monday, May 19, 2014
Posted: 6 am ET

Another investment saying that didn't make it to my favorites list earlier this year was, "Never touch principal." Income-oriented investors like dividend and interest payments, but with interest rates having been held down for so long, it's been frustrating, especially for retirees trying to earn enough income off their retirement nest egg. Raiding the nest egg for income raises the concern that the retiree may outlive his or her savings. This post considers how to harvest capital gains in your retirement portfolio.

Since the financial crisis, the Federal Reserve has flooded the market with liquidity by keeping short-term interest rates low. Its actions have forced investors to take on more risk in looking for investment returns. So-called quantitative easing by the Federal Reserve kept pumping liquidity into the financial system when lowering rates further became problematic. Even now, with the Fed reducing its purchases of Treasuries and mortgage-backed debt, it is still purchasing $45 billion per month of these securities -- at least until its next meeting in mid-June when it's expected to further taper these purchases.

The total return on an investment considers both its income yield and any capital appreciation. For example, the total return on the Standard & Poor's 500 index in 2013 was 32.39 percent. The dividend yield for 2013 was 1.98 percent. That means that the capital gains yield was approximately 30.41 percent. Let's say you've had $100,000 in the S&P 500 since the beginning of 2013. At the end of 2013, the investment would be worth about $132,390, with about $1,980 of that representing cash dividends.

Clearly, 2014 would be a good year for retirees to meet some of their retirement income needs by taking a long-term capital gain on part of that position. Qualified dividend income and long-term capital gains are taxed at the same marginal federal income tax rate in taxable accounts. They're taxed the same in tax-deferred retirement accounts, too. Unfortunately, that's as ordinary income. Limiting your withdrawals to just dividend or interest income just doesn't make sense.

As I write this post, the 10-year Treasury note is yielding less than 2.5 percent. CNBC reports that 148 stocks in the S&P 500 currently have a dividend yield higher than the yield on the 10-year Treasury note. The thing to remember is that dividend yields go up when stock prices go down, and stock prices going down isn't good for the retirement nest egg.

For retirees, are you in the "never touch principal" school, or are you willing to harvest some capital gains to meet your income needs? Here are seven ways to stretch your retirement income and ideas for managing your retirement nest egg.

Follow me on Twitter: @drdonsays.


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