Living off dividend payouts in retirement is a dream come true. The passive income stream provides many retirees with cash flow to fund their retirement lifestyle.
It’s a very attainable goal if you have the right dividend strategy in the works. Keep reading if you want to live off dividends and enjoy retirement with financial freedom.
What are Dividends?
First, let’s talk about what dividends are and how they work. When corporations make profits, they pay their shareholders dividends. So dividends are a percentage of the company’s profits.
When you buy shares of a particular stock, you’re eligible for dividend payouts. The company decides how often these payouts happen.
They could come monthly, quarterly, semiannually, or annually. Dividends are paid out as shares of stock or cash.
Companies that Pay Dividends
Not all companies pay dividends to their investors. For example, a company that’s considered a growth stock will likely reinvest all its profits into fueling its growth.
The amount and frequency that dividends are paid to investors also vary.
That’s why it is important to look at the track history of companies to understand what stock dividends to expect. Companies that have a long record of increasing their dividends are called “Dividend aristocrats”.
Why get into Dividend Investing?
Dividends are a type of passive income. This means you’re making money without doing anything to earn it.
The interest income you earn through bonds or through capital gains by selling stocks at profits is different from dividends.
Living off dividends can potentially allow you to cover living expenses and other costs. lts another income stream that’s ideal for those planning for retirement.
In retirement planning, you may have mapped out many sources of money, including real estate investment trusts, retirement funds, pension income, and social security income.
Building a strong investment portfolio ensures you have enough money to maintain your retirement life.
With the right dividend investing strategy, you can live off dividends, even without having other sources of income. Let’s go into learning more about how to build passive income using dividend strategies.
How much do you need to Retire with Dividend Income?
The investment strategy you choose is largely dependent on determining how much you need. Your annual income requirement, spending habits, and living expenses all play into how much you need.
Figuring out your budget and spending needs to live off dividends means considering factors like:
- Where will I live? The cost of living varies depending on your geographic location. Food, housing, and other necessities must be factored in. You may consider whether you’ll move somewhere less expensive when you retire.
- What medical conditions will I need treatment for? The cost of health care in the U.S. is an especially important consideration.
- How do I get to places? Places with good public transit or are highly walkable may mean you can get by without a car. Not having to maintain a car can lower your overall expenses.
- Will I have to pay for my kids or other dependents? If you’re supporting a spouse or your kids, you’ll need more money to live off dividends.
- How much money do I need for discretionary spending? Aside from your basic needs, what do you plan to spend on other areas like travel and entertainment?
- When do I plan to retire? The age you plan to retire makes a big difference in how much money you can accumulate into dividends. Retiring at 70 versus 65 provides you with five more years to acquire more dividend stocks.
- When am I starting my portfolio? If you’re starting your portfolio of dividend-paying stocks at 25, you’ll have many more years to grow it than if you start when you’re 35.
We’ll use the following formula to determine what you’ll need to live off dividends:
Desired Dividend Income/Dividend Yield = Estimated Portfolio Needed
Let’s say that you want to have at least $40,000 in dividend income each year. Dividend yields will vary, but you can expect a yield between 1% and 6%.
In the above scenario, here is the size of the portfolio that you’ll need for each situation:
- $2,000,000 portfolio with a 2% yield
- $1,333,333 portfolio with a 3% yield
- $1,000,000 portfolio with a 4% yield
- $800,000 portfolio with a 5% yield
- $666,666 portfolio with a 6% yield
Considerations with Dividend income
While the formula for determining how much you need to live off dividends is simple, there are some risks to using this strategy. Consider these potential downsides below:
Dividend payments are considered taxable income because they come out of a taxable brokerage account or a traditional 401(K) or IRA.
Planning is everything when determining how much money you’ll need to live off dividends. Factors like rising interest rates, high inflation, and other economic turmoil could affect your portfolio’s yield.
Even high dividend yield stocks have lower return years. Some companies may decide to focus more on growth, resulting in lower dividend yields for investors.
Due to these potential headwinds, it’s smart to give yourself some padding when it comes to dividend income. Consider overestimating how much you’ll need when you retire in case you lose money due to some of these risks.
Another option is to look at other retirement income sources that could provide additional streams of income. Investing in real estate property is a good option in these cases.
Evaluating Dividend Stocks
If you’re building a portfolio that allows you to live off dividends, you might opt to go with the companies with the highest yield. However, there are a lot more factors to consider than just the dividend yield when evaluating stocks.
There is often a risk tradeoff when opting for stocks with the highest dividend yield. You can calculate the dividend yield by dividing the annual dividend by the price of one share of stock.
For example, if you have a stock that pays $2 a year and it costs $100, the dividend yield is 2%.
The inverse relationship between the stock price and its dividend yield. That means if the price of one goes up, the other comes down. So if you pick a stock for its high dividends, your stock’s value might be dropping in price. That dividend yield isn’t going to make up for that loss in money.
Consequently, your best bet is to review the sustainability of a dividend yield before purchasing it.
Choose dividend stocks by looking at important things like the following:
- Dividend yield – The percentage the company pays out in dividends divided by its stock price
- Dividend payout ratio – How much a company pays out to investors in dividends against its net income
- Company fundamentals– Includes factors like price to earnings, earnings per share, and other financial health ratios
Be sure to look at the company’s overall dividend history. This means looking at how consistently and often dividends have been paid year over year, the frequency of the dividend payout (has it increased?), and if the current dividend payout seems sustainable.
Finding dividend stocks can be hard. Dividend investors must also ensure they have enough diversification in their portfolios.
Luckily individual dividend stocks aren’t the only answer. You can live off dividends by investing in exchange-traded funds (ETFs) that focus on dividend growth.
These dividend growth ETFs look for stocks that have a high likelihood of growing their dividends. There are ETFs that focus solely on dividend-paying stocks if you are looking for current income.
Dividend income is considered taxable income. The tax rates you’ll be subject to depend on the type of taxable account in which the dividend stocks are.
For example, you won’t pay taxes on dividends while they are reinvested with a traditional retirement account. The dividend payments become taxable once you start taking them as distributions and are taxed at ordinary income rates.
Dividend income from a taxable brokerage account will be taxed based on these two tax treatments:
- Qualified dividends – Taxable at the discounted long-term capital gains rate. This varies from 0%, 15%, or 20%.
- Ordinary dividends – Taxable at the ordinary income tax rate. This range is from 10% to 37%.
Dividends that are reinvested dividends or taken as distributions from after-tax accounts like a Roth 401k or IRA won’t be taxed.
These two types of taxation can significantly change your numbers. To live off dividends, you must factor this in.
Bottom Line: Investing To Live Off Dividends
Living off dividends is an achievable goal with good planning. Your cash flow needs will depend on where you plan to retire, the lifestyle you want to live, and your annual expenses. Carefully consider these factors to make a realistic estimate of how much dividend income you’ll need to sustain yourself.