For many investors it is an article of faith: Never spend principal.
In other words, if you need to take money from your investments to live on, withdrawals should be confined to interest and dividend earnings. A retiree or long-term investor should never, ever, dip into the investment itself, whether it’s a stock, bond, mutual fund or bank savings. At least, that’s the common wisdom.
But sticking to this rule can be pretty difficult these days. Fixed-income yields are terribly low, with the average one-year certificate of deposit paying just more than 1%, according to the BankingMyWay.com Survey. The 10-year U.S. Treasury note pays just less than 3.2 %. And the average dividend yield on stocks in the Standard & Poor’s 500 is a mere 2.3%.
But seeking big dividends can mean taking more risk. Risk is OK during the investing phase of your financial life, but it’s less appealing during a withdrawal phase like retirement.
So how important is the "never spend principal" rule?
It’s a great way to impose discipline on yourself, but on a purely financial basis it really isn’t necessary.
In some respects it is an old-fashioned rule, rooted in the days when dividend earnings were a prime reason for owning stocks. In the early 1950s, for example, the S&P 500’s dividend yield was higher than 7%.
Today, many companies believe shareholders benefit more if earnings are plowed back into research or plant expansion instead of being distributed as dividends. In theory, this reinvestment boosts the share price.
Indeed, many shareholders prefer this approach. Tax must be paid on dividends the year they are received, while tax on gains in share price is not owed until after you sell the shares. Delaying the tax bill means leaving more of your money in your accounts to compound.