Retirement Myth: Never Spend Your Principal

The conventional wisdom in retirement planning is to never spend your principal once you’re retired. That would make good sense in many cases, except for that little collection of rules overseen by the IRS known as the Internal Revenue Code. As the saying goes, “it’s not what you make, it’s what you keep” that you can live on.

“What you make” in the investment world is earnings. The IRS typically taxes those earnings in one of two ways: ordinary income or capital gains. Ordinary income rates run as high as 35%, while capital gain rates max out at 15%. Given a choice, would you rather have $1 of ordinary income or $1 of capital gain income?

I’d take the capital gain income every time. In a worst-case scenario, I’d keep only 65 cents of $1 in ordinary income, but I’d keep 85 cents of $1 of capital gains. When I pay my bills (I don’t know about you), the gas station, the power company and everyone else really don’t care if I pay them with “ordinary income” dollars or “capital gain” dollars. It’s all the same to them. But not to me.

So especially in retirement, I would want to keep as much money as I can after taxes. To do that, I need to generate “capital gain” income. Normally you would do that by buying an investment in some type of asset (let’s assume it’s stock) at a low price, hold for it least a year, and then sell it for a higher price. Then my profit on that investment would be taxed at the lowest rate possible, that 15% capital gain rate.

But to do that as a retiree would mean spending some of my principal. That seems to fly in the face of that conventional wisdom though. So let’s look at a quick example. Assume you have $100,000 to invest in either a CD yielding 2%, or a stock that you think will grow 6% in the next year. A year goes by and all comes to pass as expected. Your CD is worth $102,000, and your stock is worth $106,000. If you need to pull $5,000 out, which do you choose?

If you’re in the highest tax bracket (35% income, 15% capital gain), you only keep $3,250 of the income from the CD. If you sell $5,000 of stock, you keep $4,250, which is $1,000 more than the CD. So I know what I’d do—sell the stock. Because after taxes, I’m ahead of choosing the CD.

But there’s this emotional hang up we have with “spending principal.” Let’s say that originally I started with 10,000 shares of stock at $10 a piece, and now they are worth $10.60 (for a total value of that $106,000 in this example). To generate that $5,000 of income from stock, I have to sell about 472 shares. That’s 472 shares of my original investment, my sacred principal.

Here’s a little secret you may not know about your investment dollars: they’re not sentient. They don’t know if they are or are not “principal.” And they don’t care if you sell them or not. Think about the math behind our stock example for a moment.

Even after you sell 472 shares, you’d have 9,528 shares left over, at a value of $10.60 per piece. That comes out to about $101,000 in total value. Your original “principal” was $100,000, and even after selling some “principal,” you’re still ahead of the game.

So contrary to the conventional retirement wisdom you may have heard all your life, there are situations (thanks to the IRS) when it makes perfect economic sense to spend some of that sacred principal. Remember the saying, “Don’t let the tail wag the dog?” In retirement, don’t let a myth run your finances. Instead, run the numbers for your own personal situation, which I can almost guarantee will be different than a general platitude you read in a personal finance magazine or heard presented as an unbreakable rule at a money management seminar.

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About Mike Wilson

Michael L. Wilson, MBA, CFP®, CRC®, is the owner of Integrity Financial Planning. Prior to founding Integrity in 1998, he worked for two years as a faculty member at the College for Financial Planning in Denver, training other financial advisors. Mike has 10 years of experience in the mutual fund industry, having worked with Fidelity Investments and Invesco Mutual Funds. He holds an MBA in Finance from Baylor University. Learn more about his work at www.integrityplanner.com.
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