Content of the material
- The Power of Dividends
- Hypothetical Dividend Portfolio
- How Much Invested to Live Off Dividends? (Calculation)
- How long will it take to accumulate the required sum?
- How can you account for inflation and use an individual investment account to increase savings?
- Dividend Tax Considerations
- Living Off Dividends Calculator
- What Is a Realistic Dividend Yield?
- Dividend Terminology
- Dividend Dates
- Dividend Stock Glossary
- What is a Good Dividend Yield?
- Clipping the coupon: adding bonds to an income stream
- Searching for yield: comparing income in stocks vs bonds over time¹
- Buying individual bonds vs bond funds
- Dividend ETFs
- Concluding Thoughts
The Power of Dividends
While dividends are a great way to generate income in retirement, dividend income can be a tremendously powerful wealth compounding tool for those that aren’t yet near retirement.
This method of compounding wealth can create a much bigger nest egg from which to draw passive income, and therefore make it easier to achieve the goal of living off of that income.
Francisco Murillo, a Certified Financial Planner at Snowden Lane Partners has experience in working with clients and their dividend portfolios. He offers,
“Aside from the economic aspect (income), think of some of the intangibles of investing in a dividend growth portfolio, especially one that is consistently increasing its payout. In order to do this year after year, a company has to have sufficient earnings and cash flow to pass on to its shareholders. In many ways you can think of it as a barometer of a company’s “health.” A healthy company can translate to a healthy portfolio – and that bodes well for your retirement.”
Compounding is a simple concept; the investor sees larger dollar-based returns for the same percentage return each year the principal balance of the portfolio grows.
In other words, if an investor starts with $1,000 and earns a 5% return in the first year, whatever returns are produced in year 2 will be amplified by the fact that the starting balance is 5% higher than it was the previous year.
In our example, it’s a modest sum of $50, but over time and in larger amounts, this compounding can make an enormous difference to the balance of one’s portfolio.
In the above example, we assumed a capital gain of 5%, but dividends can play an important role in compounding as well because any funds received from shares the investor owns can be reinvested into the same stock or a different dividend stock.
This offers a sort of double compounding, because not only does the balance grow, but it means the investor also owns more shares from which they can draw dividends.
This creates a virtuous cycle of investing and reinvesting that can have some truly staggering impacts on the balance of the portfolio over time.
Remember: that if the ultimate goal is to live off of dividends, one must first accumulate enough in their portfolio to make it work.
We’ll touch more on that a bit later, but for now, let’s see the power of dividends.
Below is a simple example where we make some basic assumptions about a hypothetical portfolio. For our purposes, and to keep things simple, we’ll ignore the impact of taxes (more on that below as well) and transaction costs.
We’ll also assume that this investor achieves a steady 3% annual average yield on their portfolio, and achieves a steady 4% annual capital gain on the portfolio. Of course, the real world isn’t this simple, but we are simply trying to demonstrate the power of compounding dividends over time.
Using those assumptions, we can see two scenarios below. The first one is where the investor takes the 3% of dividends received each year and reinvests them 100% back into the portfolio.
The second scenario assumes the investor removes the 3% in dividends from the account and therefore does not reinvest the proceeds. What we see is a powerful example of what compounding can do and specifically, reinvesting dividends.
Hypothetical Dividend Portfolio
|Year||Balance w/ reinvestment||Balance w/o reinvestment|
In this hypothetical example, we can see that the portfolio with reinvested dividends is worth more than twice that of the one that doesn’t reinvest over a period of 25 years or more. There are no other differences in these scenarios other than the reinvesting of dividends, but the impact is profound, especially over longer time frames.
This is part of the reason why we think dividend stocks are the proven way to build wealth over time, and dividend stocks are not just for those that need the income to live. Dividends are a terrific compounding tool as well.
Now, let’s take a look at the tax implications of dividends for investors.
How Much Invested to Live Off Dividends? (Calculation)
Annual Income You Want / Dividend Yield = Amount You Need Invested
If you want a dividend income of $70,000 and your average dividend yield is 4%, you would need $1,750,000 invested.
Here’s a chart to help you visual the amount of shares needed to live off dividends in increments of $1,000 yearly income.
How long will it take to accumulate the required sum?
How can you live comfortably off stock dividends? To reach an income of $100 per month, you need to invest $40,000. You can accumulate this amount in about 7 years. To reach this amount, you need to save about $400 every month ($5,000 per year) and have a return on investment of at least 5% per year. You must invest all the resulting profits in the purchase of new shares. In the first year, you will set aside $5,000 and get an income of $250 from interest. In the second year, you will have saved up $10,250 ($5250 from last year plus $5,000 this year) and you will receive a yearly interest income of $763. In 7 years, you will have accumulated $40,710.
Notice the difference. If you save $100 per month, you will need as much as 21 years to get to $40,000.
Please beware that these are very approximate calculations. Many factors might influence the growth of dividend income, such as the size of the company’s profit, the increase or decrease in payments on shares, macroeconomic indicators and the state of the economy as a whole.
How can you account for inflation and use an individual investment account to increase savings?
The undoubted advantage of dividend stocks is the automatic accounting of inflation. The interest on the shares is paid out of the company’s profits. Therefore, the change in the level of inflation does not affect them as much as bank deposits or other transactions.
For instance, a company accounts for inflation when raising the final cost of its products as a response to an increase in production costs. Its cash flows grow, it preserves its profit and pays dividends, protecting investors from inflation.
Dividend Tax Considerations
Don’t forget to factor taxes into your dividend calculations. If you’re receiving your dividends from equities in a traditional 401(k), IRA, or taxable brokerage account, they will be taxable income.
However, they’ll be subject to different tax rates. With a traditional retirement account, you won’t pay taxes on dividends while you reinvest them. Once you start taking them as distributions, though, they’ll be taxable at ordinary income rates.
If you take your dividends from a taxable brokerage account, they will receive one of two tax treatments, depending on whether they are:
- Qualified: These are taxable at the discounted long-term capital gain rates of 0%, 15%, or 20%.
- Ordinary: These are taxable at ordinary income rates, which range from 10% to 37%.
If your dividends come from after-tax accounts like Roth 401(k)s or IRAs, you can avoid the issue altogether. You won’t pay taxes on reinvested dividends or those you take as distributions.
Make sure you know the significance of these two types of taxation, as they can skew your numbers significantly.
👉 For example, $30,000 in qualified dividends taxable at 15% is $25,500. The same amount in ordinary dividends taxable at 24% is $22,800. That’s $2,700 less each year and $225 less per month.
It’s always a good idea to get personalized tax advice regarding the implications of any investment strategy. Consider discussing your approach with a tax expert like a Certified Public Accountant or Enrolled Agent, or read what the IRS has to say about dividends.
📘Learn More: If you need to brush up on the different types of personal income taxes, take a look at our overview of the subject: Taxation 101: How Do Taxes Work For Individuals?
Living Off Dividends Calculator
To simplify things for you, check out this dividend reinvestment calculator. This free tool reveals how your portfolio value grows when dividends are reinvested.
You want to get the most realistic growth prediction. I recommend choosing a stock and researching the needed information.
That way you’re using real numbers from a real stock that you own or want to own. It will produce real growth numbers for you. Not ones that are fabricated.
What Is a Realistic Dividend Yield?
Dividend yield refers to the amount of the dividend divided by the current stock price. You generally want a higher dividend yield as a 10% yield will always be better than a 2% yield. However, a typical dividend yield often falls between 1% and 6%. Indeed when dividends rise as high as 10%, something fundamental is often up with a company and it’s a red flag.
A yield between 4% and 6% is considered quite good in most circumstances. See the table below for examples of common dividend yields and how they relate to annual dividend income.
|Details||Example One||Example Two||Example Three|
|Investment Portfolio Size||$500,000||$1,000,000||$2,000,000|
|Dividend Income||$20,000/ year |
Below is a detailed list of important dividend terms and dates to familiarize yourself with if you intend to invest in dividend paying stocks.
Declaration Date: This is the date a company says it will be paying its dividend. A declaration statement will include details of the following: amount paid in dividends, the record date and the date of payment.
Ex-Dividend Date: You must own the dividend paying stock before this date in order to receive the next scheduled dividend payment.
If you were to purchase the stock on or after the ex-dividend date the dividend payment still goes to the previous owner of the stock.
Payment Date: This is the predetermined date that the company will make dividend payments to shareholders on record.
Dividend Stock Glossary
Adjustable Rate: The rate in which an annual dividend can vary depending on certain factors.
Average Daily Volume: The average number of shares traded per day of a security in a given time frame.
Backwardation: When a commodity’s spot price is higher than the future price.
Balance Sheet: A financial statement of a company and it’s assets. Including both what it owns (assets) and what it owes (liabilities) as of a specific date. Usually reviewed on the last day of a company’s fiscal quarter.
The difference between the company’s assets and liabilities determines the net worth.
Basis Point: An interest rate measurement equal to one-hundredth of one percent. For instance, 50 basis points equals 0.5 percent and 100 basis points equal one percent.
CAGR: CAGR stands for compound annual growth rate and is the growth rate of an investment year over year.
Callable: The opportunity the issuer has to redeem a security prior to its maturity.
Call Date: The earliest date a preferred stock can be called.
Call Price: The price the issuer must pay to redeem a stock when called.
Capitalization Rate: Capitalization rate, otherwise known as cap rate is the property’s net operating income divided by it’s purchase price.
A higher cap rate generally means a higher return on investment.
Cumulative: A company issuing “cumulative” preferred shares must pay any skipped dividends on those shares before common stock dividends are paid and before the preferreds are redeemed.
Declaration Date: Date that dividend is announced.
Dividend Capture: This strategy involves buying a dividend paying stock at a precise time in order to capture the dividend payment, followed by the selling eh stock shortly after.
What is a Good Dividend Yield?
Whether a dividend yield is “good” or not is really in the eye of the beholder. For instance, whether a yield is good enough is based upon many factors, including how focused an investor is on capital gain potential, dividend growth potential, dividend safety, and more.
To help us understand this, let’s look at a few examples. For our first example, let’s assume a 25-year-old investor that has 40 years until they retire. This investor would do well to focus on dividend growth potential and companies that can stand the test of time in terms of dividend longevity.
These companies, however, tend to have lower current yields because investors bid up the stock’s valuation in anticipation of future growth. Thus, a yield of 1.5% or 2.0% may be deemed to be sufficient for this investor.
On the other end of the spectrum, let’s say we have an investor that is 65 years old and has just retired. This person is almost certainly not particularly interested in dividend growth potential and is likely much more focused on dividend safety and current yield.
Thus, this investor may have a “good enough” hurdle rate of 4%, or even 5% or 6% depending upon their needs.
Therefore, there is no “right” answer in terms of what dividend yield is good enough because the answer is different for every investor. One must take into consideration their portfolio size, their investment time horizon, their goals, their risk tolerance, and numerous other factors.
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Clipping the coupon: adding bonds to an income stream
Bonds are called fixed income because they offer regular (usually fixed) interest (coupon) payments. As such, bonds can provide a steady cash flow for investors. The income component is a key reason investors own bonds in their portfolio.
A bond’s coupon is a fixed interest rate and represents a percentage of the par value that the buyer will receive in ongoing interest payments. For example, a bond with a $1,000 par value and a 5% coupon will make annual interest payments of $50 until the bond matures and the par value is fully repaid. Coupon payments may occur more frequently depending on the bond.
While bonds can add stability and income to a portfolio, as interest rates have declined over the last few decades, yields have followed suit. The relationship between interest rates and bond yields is an important one.
When rates decline and yields drop, it supports equities, as investors seek out riskier assets for higher expected total returns since stocks provide the opportunity for price appreciation and comparable or even more favorable income.
Searching for yield: comparing income in stocks vs bonds over time¹
As with equities, the prices of underlying assets, correlations, and fluctuations in the market can impact your ability to live off portfolio income.
Buying individual bonds vs bond funds
Are there benefits to investing in single bonds vs shares of a bond fund? There are several important differences between owning individual bonds and investing in bond funds. For individual investors, investing in bond mutual funds or ETFs is often the best way to gain exposure.
As with stock funds vs individual stocks, owning a bond fund provides greater diversification and liquidity. Building a diversified bond portfolio on your own can be difficult due to minimum purchase sizes. Some corporate bonds may require a minimum purchase of $250,000 or more. Small buyers won’t be given as favorable pricing offers from dealers who favor large institutional purchasers.
But when you own bonds outright, you have the most control over how long you hold that particular security. Holding an individual bond to maturity gives investors a reliable payment of par.
As you look to bonds for income, consider the pros and cons of sector diversification, duration, and credit quality. For example, high yield bonds can offer additional income and risk (of default). High yield (or junk) bonds are also strongly correlated with stocks, which limits their diversification power. Also, corporate and long-term bonds tend to be the most sensitive to changes in interest rates. There’s a lot to consider.
It can be hard to find the right stocks for dividends. Furthermore, achieving sufficient diversification is even more challenging for small investors.
Fortunately, some ETFs deploy dividend strategies for you. Dividend growth ETFs focus on stocks that are likely to grow their dividends in the future. If you are looking for current income, high-dividend-yield ETFs are a better choice.
The importance of planning for retirement and investing at an early age cannot be overstated. In fact, the sooner you start, the better it would be due to the compounding of investment returns. If you’re already 50 years or older, it becomes even more critical to consider various options to see how you can reach your goals in a realistic manner. Even though it’s always prudent to start saving from an early age, it is never too late. Even if you have not saved much or just have modest savings by the time you turn 50, there’s still ample time to make up for the lost time. However, the more you delay it, the harder the choices will be.
In the second section of the article, we demonstrated a strategy with two buckets that would not only provide a high level of income but would also lower the volatility and drawdowns to a large extent. It will provide growth during the boom years and preserve capital during recessionary times or big corrections. If we invest with a sound strategy that we can live through good times and bad, it is not too difficult to get 9%-10% annualized returns on your investments.