Dividends can be used to create passive income in an investment portfolio or grow wealth over the long term through reinvestment. Knowing how to live off dividends may be central to your retirement planning strategy if you want to avoid running out of money while also managing investment risk. The income you generate from dividends can be a welcome supplement to Social Security benefits, a pension or withdrawals from tax-advantaged accounts. Making the most of dividend income means knowing how to generate it and how to use it to your advantage.
A financial advisor can also provide invaluable advice on helping you set up 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 represent a percentage of a company’s profits as paid out to shareholders. In other words, this is money you receive simply for owning shares of a particular stock. Depending on the company, dividend payouts may come monthly, quarterly, semiannually or annually. Dividends may be paid as cash or as shares of stock.
Not all stocks generate dividends for investors. For instance, a growth stock may not pay dividends if the company is reinvesting all profits in growth. And dividend stocks aren’t all the same, in terms of what they pay out to investors and how frequently those payouts occur.
Dividend aristocrats and dividend kings, for example, represent the companies that have the longest track records for increasing dividend payouts year over year. Meanwhile, some companies that pay dividends regularly may reduce or eliminate their payout due to reduced profitability.
Dividends are a form of passive income; in other words, this is income you don’t have to do anything to earn. In a portfolio, dividend income is separate from interest income generated by bonds or the capital gains you may realize from selling stocks at a profit. It’s also different from the passive income you may generate from owning real estate investments.
How to Live Off Dividends
Knowing how to live off dividends successfully means finding the right balance between the income your investments generate and the rate at which you spend that income down. Your retirement age, expected longevity and retirement needs can all factor in to your calculations. For example, the 4% percent rule is a commonly used rule of thumb for retirement withdrawals. This rule says you should be able to withdraw 4% from your investments per year in retirement to avoid running out of money.
But how does that rule work for dividend investing?
If you want to live off dividends, you should first consider how much you can realistically afford to withdraw from your portfolio once you retire as well as income you may receive from other sources. Social Security benefits, pension benefits and withdrawals from a 401(k) or IRA may all come into play here for determining your target drawdown rate.
Estimating how much you’ll need to live off of in retirement can help you determine how much dividend income you may need to fill gaps left by other income streams. This can also be useful in determining which dividend investments to make to produce a level of returns sufficient to meet your needs. Again, some dividend stocks can produce higher returns than others.
It’s also important to consider how and where taxes fit in when planning for dividend income. Dividends can be subject to capital gains tax which makes it important to diversify with both tax-advantaged and taxable accounts. Also, keep in mind that even if you’re reinvesting dividends in additional shares through a dividend reinvestment plan (DRIP), they’re still subject to tax. Talking with a financial advisor or tax professional can help you choose the right asset location and allocation for dividend income investing.
How to Invest With Dividends
There are two main paths for building a dividend-focused portfolio: investing in individual dividend-paying stocks and holding dividend funds.
Owning individual dividend stocks has both pros and cons. On the pro side, you can pick and choose which companies you want to invest in based on your risk tolerance and dividend goals. As you chose dividend stocks, it’s important to consider things like:
Dividend yield
Dividend payout ratio
Company fundamentals
Dividend yield tells you how much a company pays out in dividends each year relative to its stock share price. The dividend payout ratio represents how much a company pays out to investors in dividends relative to its net income.
Company fundamentals refer to things like price to earnings, earnings per share and other ratios that measure financial health. When selecting dividend stocks, it’s important to not be sidetracked by a high dividend yield only, as this may not paint a true picture of the company’s financial health.
Instead, consider the company’s overall dividend track record in terms of:
Consistency and how often dividends have been paid out over time
How frequently the dividend payout has increased
Whether the current dividend payout is sustainable, based on what the company’s fundamentals tell you
If you’d rather own a collection of dividend investments you can consider dividend mutual funds or exchange-traded funds (ETF) instead. This can be a simpler way to diversify with dividend stocks. When considering dividend funds or ETFs, consider the strategy the fund employs and how that aligns with your overall investment approach.
For example, a dividend index fund or ETF attempts to mimic the performance of an underlying benchmark index. Growth dividend ETFs, on the other hand, may focus on stocks that are poised to grow their dividend payouts over time. Meanwhile, high yield dividend ETFs may concentrate holdings on the stocks paying the highest dividend yields.
Also, keep costs in mind. With dividend stocks and dividend ETFs, it’s important to look for an online brokerage that charges zero commission fees to trade. You should also consider the expense ratio of a dividend mutual fund or ETF before investing, as that can determine how much you pay to own the fund on an annual basis.
Bottom Line
Dividend stocks and dividend ETFs can provide diversification in a portfolio and they can also generate income for retirement. Being conscious of how you plan to spend once you retire and what type of income you’ll need can help you devise a plan for how to live off dividends for the long term.
Tips for Retirement Planning
If you’re not sure how to start with dividend investing, talk with a financial advisor about how this strategy might fit into your overall financial plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Planning for retirement can be overwhelming. You can get a good estimate of what you’ll get after you quit working with a retirement calculator.
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Source: https://finance.yahoo.com/news/much-live-off-dividends-130049139.html