How Dividends Can Make the 4% Rule Easy

A popular retirement investing strategy known as the 4% withdrawal rule could be improved, provided you're willing to take a little risk by investing in high-quality dividend stocks.

Aug 28, 2014 at 9:57AM

There are millions of people in the United States currently in or near retirement. Many of them are looking for investment advice to manage their retirements. One of the more common pieces of advice calls for withdrawing 4% of your retirement nest egg every year to live on. At first glance, this makes sense, because life's inevitable expenses don't just stop once you leave the workforce. And, by withdrawing 4% of your retirement savings every year, you should have enough money to last you through retirement.

There may be a way to modify this strategy that could provide income to live on during retirement while adding the benefit of not draining your nest egg. Instead of withdrawing 4% of your money every year, you could invest in dividend stocks that pay a 4% dividend yield.

Although investing in dividend stocks is not risk-free, draining your nest egg every year carries the risk that you will outlive your retirement savings. If you're willing to dip your toes into the stock market, these high-quality dividend stocks can provide a nice spin on the 4% withdrawal rule.

The drawbacks of the 4% rule
One major disadvantage of the 4% rule is that for retirees whose savings are primarily invested in stocks and other investments, having to sell some of those investments in order to reach that 4% drawdown each year may seem far from ideal. This is a particular concern when interest rates are low, as yields on traditional savings vehicles like bank certificates of deposit are next to nothing.

A practical solution to these challenges is to invest some of your savings in dividend stocks so that you can earn some income from your investments without having to sell them off each year. This, of course, requires you to accept the risk -- and the potential reward -- of investing in equities.

A couple of ideas to get you started
There are still stocks that provide high yields without requiring investors to assume high risk. A great place to look would be the telecommunications sector. Two, in particular, are AT&T (NYSE:T) and Verizon Communications (NYSE:VZ).

Telecommunications companies have historically provided high yields, which investors crave for their income potential. For example, AT&T and Verizon pay dividend yields of 5.3% and 4.3%, respectively. Both companies can afford such generous payouts because their stable businesses produce lots of cash flow. In the first half of the year, AT&T raked in $5.2 billion in cash flow and paid $4.7 billion of that in dividends. For its part, Verizon generated $6.3 billion in cash flow and paid $3.5 billion in dividends over the same period.

Dividend investing: A twist on the 4% retirement rule
Investors in or nearing retirement are in a bind. Interest rates are at historic lows, meaning there's little income potential from traditional savings vehicles. A solution to this could be investing in dividend stocks.

To be sure, dividend stocks are not without risks. Investing in the stock market always carries risk. However, the risk of outliving your money should be considered, as well. Instead of withdrawing 4% of your nest egg each year and potentially running out of money, invest in dividend stocks and let the income they provide help make up for the slower drawdown of your retirement savings.

With dividend stocks like AT&T and Verizon, you can earn more than 4% from your investment, and your income should rise every year thanks to dividend growth. High-dividend stocks can be a great way to execute the 4% retirement rule.

How to get even more income during retirement
Social Security plays a key role in your financial security, but it's not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.

Bob Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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