Dividends can be used to create passive income in a investment portfolio or increasing long-term wealth through reinvestment. Knowing how to live off dividends can be central to your retirement planning strategy if you want to avoid running out of money while managing investment risk. The income you generate from dividends can be a welcome addition to Social security benefits, a pension or withdrawals from taxed accounts. Making the most of dividend income is knowing how to generate it and how to use it to your advantage.
A Financial Advisor can also provide you with valuable advice to help you implement a retirement investment strategy that includes dividend income.
What are dividends?
If you want to know how to live off dividends, it helps to know what they are first. Dividends are a percentage of a company’s profits as paid out to shareholders. In other words, it is money that you receive simply for owning shares of a particular security. Depending on the company, dividend payments can be monthly, quarterly, semi-annually or annually. Dividends can be paid in cash or in the form of shares.
Not all stocks generate dividends for investors. For example, a growth stock may not pay dividends if the company reinvests all profits in growth. And not all dividend-paying stocks are the same, in terms of what they pay out to investors and how often those payouts occur.
Dividend Aristocrats and dividend kings, for example, represent companies with the longest track record of increasing dividend payouts year over year. Meanwhile, some companies that regularly pay dividends may reduce or eliminate their payout due to reduced profitability.
Dividends are a form of passive income; in other words, it’s income you don’t have to do anything to earn. In a portfolio, dividend income is separate from interest income from bonds or capital gains you can realize by selling stocks for a profit. It is also different from the passive income you can generate by owning real estate investments.
How to live off dividends
Knowing how to successfully live off dividends means finding the right balance between the income your investments generate and the rate at which you spend that income. Your retirement age, expected longevity and retirement needs can all factor into your calculations. For example, the 4% rule is a commonly used rule of thumb for retirement withdrawals. This rule states that you should be able to withdraw 4% of your investments per year in retirement to avoid running out of money.
But how does this rule work for dividend investing?
If you want to live off dividends, you must first consider how much you can reasonably afford to withdraw from your portfolio in retirement as well as what income you may receive from other sources. Social Security benefits, retirement benefits, and withdrawals from a 401(k) or IRA can all come into play here in determining your target drawdown rate.
Estimating how much you’ll need to live on in retirement can help you figure out how much dividend income you might need to fill in the gaps left by other sources of income. It can also be useful in determining which dividend investments to make to produce a sufficient level of return to meet your needs. Again, some dividend stocks may produce higher returns than others.
It’s also important to consider how and where taxes fit in when planning for dividend income. Dividends may be subject to capital gains tax hence the importance of diversifying with both taxable and taxable accounts. Also keep in mind that even if you reinvest the dividends in additional shares through a dividend reinvestment plan (DRP), they are still subject to tax. Talking to a financial advisor or tax professional can help you choose the right location and asset allocation to invest in dividend income.
How to invest with dividends
There are two main routes to building a dividend-focused portfolio: investing in individual stocks that pay dividends and owning dividend funds.
Owning individual dividend stocks has both advantages and disadvantages. On the professional side, you can choose the companies you want to invest in based on your risk tolerance and dividend targets. When choosing dividend-paying stocks, it’s important to consider things like:
-
Dividend yield
-
Dividend payout ratio
-
Business fundamentals
Dividend yield tells you how much a company pays out in dividends each year relative to its stock price. The dividend payout ratio represents the amount a company pays out to investors in dividends relative to its net income.
Company fundamentals refer to things like price-to-earnings ratio, earnings per share, and other ratios that measure financial health. When selecting dividend-paying stocks, it’s important not to get distracted solely by a high dividend yield, as that may not paint a true picture of a company’s financial health.
Instead, consider the company’s overall dividend history in terms of:
-
Consistency and frequency of dividend payments over time
-
The frequency with which the dividend payment has increased
-
Whether the current dividend payout is sustainable, based on what company fundamentals tell you
If you prefer to own a collection of dividend investments, you may want to consider dividend mutual funds or exchange-traded funds (ETFs) instead. This can be an easier way to diversify with dividend-paying stocks. When considering dividend funds or ETFs, consider the strategy employed by the fund and how it aligns with your overall investment approach.
For example, a dividend index fund or ETF attempts to mimic the performance of an underlying benchmark index. Dividend growth ETFs, on the other hand, can focus on stocks that are poised to increase their dividend payouts over time. Meanwhile, high-yield dividend ETFs can focus their holdings on stocks offering the highest dividend yields.
Also, keep costs in mind. With dividend stocks and Dividend ETFs, it is important to look for an online brokerage firm that does not charge any commission for trading. You should also consider the expense ratio of a dividend mutual fund or ETF before investing, as this may determine how much you pay to own the fund on an annual basis.
Conclusion
Dividend stocks and dividend ETFs can provide diversification in a portfolio and they can also generate income for retirement. Being aware of how you plan to spend in retirement and what kind of income you’ll need can help you design a plan to live off long-term dividends.
Retirement Planning Tips
-
If you don’t know where to start with dividend investing, speak with a financial advisor how this strategy might fit into your overall financial plan. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your advisors at no cost to decide which one is best for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
-
Planning for retirement can be overwhelming. You can get a good estimate of what you will get after you stop working with a retirement calculator.
Photo credit: ©iStock.com/eggeeggjiew, ©iStock.com/Rawpixel, ©iStock.com/Cecilie_Arcurs
The post office How much do you need to live off dividends? appeared first on SmartAsset Blog.