Ignore the 4% Rule: This Is the Best Retirement Investing Strategy for Most Americans
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For decades, conventional wisdom has argued that financial planner William Bengen's famous 4% rule, which he introduced in 1994, could safely carry retirees through their golden years.
The strategy, which begins with withdrawing 4% of your retirement savings in Year One then increasing that amount proportionate to inflation in subsequent years, should theoretically result in retirees having financial stability for 30 years.
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Over time, however, critics have suggested that the 4% figure should be closer to 5%. But the issue with the strategy is not in its math. Rather, the problems are twofold:
- American life expectancy has increased by more than 27% since 1960, presenting the risk of retirees outliving their savings.
- The premise of the 4% rule is based on having to liquidate assets in your retirement account in order to generate income.
There's a better way — one that can preserve your nest egg and position you to leave behind generational wealth.
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Turn your Roth IRA into a dividend machine
Many Americans can boost their chances of generating reliable retirement income by adding a Roth IRA, or individual retirement account, to their saving plan. Because they are funded with after-tax dollars, these accounts grow tax-free and can spin off tax-free dividends if you're at least 59 1/2 years old and have held the Roth IRA for at least five years.
There are exceptions (like for foreign dividends, which can be subject to taxation). But, broadly, proceeds from Roth IRAs are not taxable as ordinary income or capital gains as they are in an ordinary brokerage accounts.
Of course, that same tax treatment applies to the sales of shares and subsequent withdrawals that retirees would need under the 4% rule. But if you retire with a dividend portfolio, the underlying assets — shares of yield-producing stocks and exchange-traded funds (ETFs) — never need to be sold in order to produce income.
Rather, they continuously generate tax-free distributions (in some instances on a monthly basis) simply for owning them. The result: Your holdings maintain their principal value rather than withering away under the withdrawals necessitated by the 4% rule.
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The dividend snowball approach
Because a dividend portfolio allows retirees to not exhaust their savings, by extension, it enables them to pass along those shares to their kin. But how is that best accomplished?
It depends on the individual investor, but it should begin long before retirement and requires finding the appropriate allocation between high-quality dividend stocks, dividend growth ETFs and premium income ETFs.
Before those dividends are needed to supplement your other sources of retirement income, it's critical to embrace a dividend reinvestment plan — or DRIP — that automatically reinvests payouts into the companies or funds that provide them.
Over time, the long-term dividend snowball strategy generates a growing income stream, with your DRIP resulting in share accumulation until the day you turn it off and begin to enjoy your portfolio's yield.
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Where should you begin?
Discussing this strategy with a financial planner is always a good start. In the interim, it can't hurt to start researching potential positions you'd like to hold in your dividend portfolio.
That can include so-called Dividend Aristocrats (e.g. Aflac and Chevron) and Dividend Kings (e.g., Coca-Cola and Walmart): companies that have increased their dividend payouts for 25 and 50 years consecutively.
These aren't flashy, AI-leveraged, headline-grabbing, high-growth stocks. But they've become income investors' go-to due to their reliable and sustainable dividend payout ratios.
For ETFs, dividend growth funds like the Schwab U.S. Dividend Equity ETF can provide a combination of share appreciation and income, while high-yield funds like the JPMorgan Equity Premium Income ETF provide market-beating yield alongside monthly payments.
Importantly, no matter what the composition of your dividend portfolio looks like, it will allow you to not worry about outliving its balance and bring you the comfort of knowing that you can leave behind the wealth you worked so hard to amass over decades.