verywizardalpaca

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1. Living off the Interest Only

If you invest $1,000,000 at 5% per year and withdraw only the interest (and nothing else), then each year you’d get about

  $1,000,000 × 0.05 = $50,000

So over five years you would “make” about

  5 × $50,000 = $250,000

—and your $1,000,000 principal would remain intact. In this case, because you’re only living off the interest and leaving the principal untouched, you wouldn’t “run out” of money (assuming the rate stays at 5%).

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2. Withdrawing More Than Just the Interest

If instead you decide that you need more money each year—for example, you withdraw a fixed amount that is higher than the annual interest—then you will start to dip into your principal and eventually run out. (This is sometimes called an annuity or “withdrawal” problem.) For instance, suppose you withdraw $100,000 each year.

Even though your investment earns 5% per year, you are taking $100,000 out when only $50,000 is earned each year. (That extra $50,000 must come from the principal.) Using the annuity depletion formula (or a financial calculator), one finds that a $1,000,000 portfolio earning 5% per year will last roughly 14 to 15 years if you withdraw $100,000 each year.

(For comparison, a more conservative withdrawal—say, about 4% of $1,000,000, which is $40,000 per year—might allow the portfolio to last indefinitely, since you’d be withdrawing less than the interest earned.)

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Summary

Living on Interest Only:

 • At 5%, you get about $50,000 per year. Over 5 years, that’s $250,000 in income—and you never touch your $1,000,000 principal.

 • In this scenario you don’t run out of money as long as the return remains at 5%.

Withdrawing More Than the Interest:

 • If you withdraw $100,000 per year (i.e. living partly off your principal), your money would last roughly 14–15 years.

 • A lower withdrawal rate (say, $40,000 per year) could make your money last much longer, perhaps even indefinitely (again, assuming a steady 5% return).

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Note:

The numbers above are very sensitive to the rate of return and the withdrawal amount. In real life you’d also want to consider factors such as inflation, taxes, and the fact that returns can vary from year to year.

So, your “income” and the longevity of your money depend entirely on the rate you earn and how much you spend each year.

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