- What is a Dividend?
- What is a Dividend Yield?
- What are the Benefits of Living off Dividend Payments?
- How to Plan a Portfolio Using a Dividend Investing Strategy
- How to Find Dividend-Paying Stocks
- Tips for Investing in Dividends
One of the most common concerns that people have is whether they have enough money saved for retirement. Living off of social security isn’t going to be enough to cover living expenses. And we’re not all able to purchase real estate properties that we can use the rental income to retire comfortably on.
It is possible to live off your retirement income through your dividend payments. It requires solid research on the investments you are considering. To live off your dividends in retirement, it’s important to start investing for retirment early. You can generate solid retirement income by choosing safe, high-yield stocks too. If you want your retirement planning strategy to incorporate dividend investing, read on to learn more.
What is a Dividend?
Dividends are typically paid out on a company’s common stocks. Companies can use different types of dividends to pay shareholders including the ones described below.
Out of the types of dividends, a company can pay its shareholders, cash dividends are the most common. These dividends are paid as cash that in most cases will be transmitted to the shareholder’s brokerage account.
Let’s use the stock, Coca-Cola(KO) as an example. You can find their history of dividend payments online or through your stockbroker’s website. If they made a dividend payout of $0.35 per share and you own 100 shares, that means you’ve earned a total of $35.
This is an alternative to paying cash that companies use. These dividends are paid through additional shares of stock. Companies may choose these types of dividends instead because they don’t have spare cash or are preserving cash to make other investments. Stock distributions in these cases are typically made as fractions that are paid for every share.
Let’s say that a company issues a 5% stock dividend. That means that they are increasing the number of shares held by shareholders by 5%. For every 20 shares, a stockholder would gain one additional share. A company that has 100,000 shares would increase its number of shares by 5,000.
Dividend Reinvestment Program (DRIPs)
This program enables investors to take their cash dividends and reinvest them into additional shares or fractional shares. This program is offered by about 650 companies and 500 closed-end funds. Shares that are purchased through DRIPs come from the company’s reserve and must be redeemed directly through the company.
A special dividend doesn’t recur like regular dividends. Special dividends are distributed often have several years of accumulated profits when there is no immediate need.
A company may issue these funds when a certain event occurs such as an asset sale. These cash distributions are typically larger than the return paid on regular dividends.
Shareholders of preferred stocks will receive this return. Preferred stocks work more like a bond than a stock. A company will typically pay out these dividends on a quarterly basis to investors. The amount of the dividends are fixed in most cases.
What is a Dividend Yield?
For people that use a dividend strategy, there are specific measurements that should be used with this type of investing. One of the most important to building a nest egg for retirement is the dividend yield. Investors can determine how much a company will pay out in dividends each year in relation to its stock price.
Expressed as a percentage, the dividend yield is calculated by dividing the dollar value of the dividends paid per share in a certain year by the dollar value of one share of stock. Dividend investors can use data from the previous year’s dividend to estimate yields for the current year. Another option is to use the latest quarterly dividend and multiplying it by 4, then divide it by the current stock price.
The dividend yield provides investors realistic expectations based on data that can be used to determine if a company will provide solid investment income. Let’s look at an example. You’re trying to determine if it makes sense to add a company to your portfolio. The annual dividend is $2 and the stock trades at $25. That means that the dividend yield is 8 percent ($2 / $25).
What are the Benefits of Living off Dividend Payments?
Creating a retirement strategy that relies on dividend payments takes careful planning. The advantages of dividend investing for generating an income stream for retirees are worth it. The reason why many investors use this strategy usually falls into one of the following reasons below.
Dividend Yields on Stocks are Better than Bonds
Bond yields tend to remain stagnant and not likely to keep up with the inflation rate. Even simply safe dividends from companies that have a history of consistent returns will outpace bond yields. Investing in the stock market with dividend investing will provide more retirement income without trading it for much more risk.
Steady Retirement Income
You’ll know the rate of return for each investment in your portfolio with dividend investing. You’ll receive dividend income through quarterly payments from the companies in your account. That’s like receiving pension income like companies used to provide to their employees. Your mind can stay at ease knowing your nest egg can provide for you during retirement.
Preserves your Retirement Savings
A portfolio that’s built to provide retirement income through dividends could keep you from dipping into your principal. Ideally, you would not have to use your principal balance as retirement income while in retirement. This investment strategy will allow your retirement funds to last longer.
Companies that make Dividend Payments are Typically Strong
Providing consistent dividends to investors is usually a sign of a strong company. To provide a dividend, a company must be profitable and have the cash to meet its other obligations. That is why companies that have a track record of paying dividends are considered less volatile and “safe” for investors.
Blue-chip stocks are made up of companies that are well established and known for their history of paying dividends. Procter & Gamble and General Mills are examples of blue-chip stocks that have established a history of over one hundred years of dividends.
Dividend Strategy is Favorable for Tax Purposes
Tax-efficient retirement withdrawal strategies are always important to consider when it comes time to retire. The income tax rate you pay when you’re working is based on the total amount of your annual income. Your tax rate changes when you reach retirement. Instead, retirees will receive a tax rate that’s based on the income from dividends and capital gains (stock price appreciation).
This tax rate is lower, creating a saving that boosts your available funds. Prolonging the life of your retirement portfolio is always a good thing.
How to Plan a Portfolio Using a Dividend Investing Strategy
So you decided to use the dividend strategy for your retirement planning. To invest in dividend companies works best with long-term planning. Growing your portfolio so the return on investment with dividends provides adequate income can’t happen overnight. Here are some steps to follow to help create the cash flow you need to cover living expenses in retirement.
Step One: Determine Your Retirement Goals
To earn the right amount of cash flow in retirement using dividend stocks, you have to make enough to cover your living expenses. How much you need will depend on the type of retirement lifestyle you want. For example, if you want to travel abroad frequently in retirement you will need more dividend income than if you want to stay close to family and watch your grandkids.
There are two numbers that are especially important to calculating the income you will need:
- Retirement Date
- Estimated annual expenditures in retirement (adjusted for inflation)
You’ll also need to consider whether the dividend income will need to cover all your expenses or just a portion. Will you have other sources of income during retirement? Some examples of investments from other asset classes include social security, real estate investment trusts, interest income from savings, and mutual funds.
Once you have all your other income sources, you can figure out what dividend yields you will need to generate using the following formula:
Annual Dividends = Annual expenditures – Other income sources
Since using dividend income to fund your retirement is more effective when it’s used for long-term planning, you will want to come back to your estimates occasionally. When you’re 30 years old and estimating what your long-term goals look like, that vision could change in a decade. With your estimates, you’re ready to move on to the next step.
Step Two: Create Your Dividend Portfolio
If you don’t have a dividend portfolio set up yet, look for one that has a low cost and fee structure. These expenses will hit your bottom line so it’s best to do research to find one that will be your long-term partner.
To get the type of return you want from dividends, you need to build the right portfolio. You can do this in two ways. The first is that you can focus on looking at stocks that pay a high dividend yield. The second method is growing your account with dividend growth stocks. Let’s dive deeper into these two.
To use the dividend yield method, you’re looking at current dividend-paying stocks and invest in those that have a high dividend yield. It’s also possible to use this method to find an index fund for the same goal as individual stocks. This simply means reinvesting dividends paid by stocks held by the fund into more shares of the fund. Or you can take those dividends as part of your cash flow. A fund that invests in the S and P 500 is generally one that could be ideal for this.
A risk of the dividend yield method is that companies with a history of being significant dividend-paying stocks could suddenly cut their dividends. Another thing to keep in mind is that the share price could have dropped, which resulted in an increase in the dividend.
The dividend growth method focuses on buying stocks whose dividend value is growing or expected to grow. You can find these future dividend-paying stocks by using online stock screeners to find stocks that have increased their dividends.
You run the same risk using the dividend growth method as you do with the dividend yield approach. There’s no guarantee that these dividend stocks will continue to pay a return. Even if you continue to see stock returns, the dividend yield could drop.
Step Three: Know the Right Dividend Investing Calculations
You can’t determine if the value you need from your dividend investment is adequate if you aren’t using the right calculations. The three that you need to know to make the most of your portfolio are:
Annual Dividend Yield
We covered this earlier, but it’s worth repeating because you will use it often as you build and monitor your portfolio. This calculation is the percentage of dividends per share received relative to the stock price. You will need to use this calculation if your goal is to live off dividends to determine if the return is enough to cover your expenses without dipping into your principal.
Dividend Growth Rate
To determine if your dividend stocks are growing that much every year, you need to know its dividend growth rate. A stock that will pay dividends that continually increase is like getting a “raise” for doing nothing. The more stocks that own that do this, the better. This calculation can be done on an annual timeframe. To determine the return rate, use the current year’s dividend per share and dividend it by last year’s. Then subtract this number by 1 to see how much (or less) the growth rate was as compared to the prior year.
Dividend Payout Ratio
Using the dividend payout ratio, you can determine the value of how much a dividend stock pays in relation to its earnings. Dividend stocks that have a high payout ratio mean that little money is being retained to reinvest into the business. Although a company may pay dividends, it can sometimes be a red flag.
For example, if earnings decline, these stocks will yield lower dividends. We want our dividend stocks to at least maintain their dividend or grow in value over time.
Step Four: Make Adjustments as Needed and Maintain
Regularly reviewing your portfolio will ensure that your getting what you need out of your dividend stocks to retire as planned. However, you need to be able to make adjustments when necessary if you’re not meeting your goals. The adjustments you will need to make if your stocks aren’t returning what you need is:
- Retire on a later date.
- Change your retirement lifestyle to reduce projected spending in retirement.
- Increase your savings; This can be done by increasing your income, lowering expenses, or both.
You’ll also need to periodically conduct some portfolio maintenance. This includes balancing the portfolio, selling stocks whose share price is overvalued, and more. Doing too much manipulation to your portfolio is a waste of time and money. But not pruning your account effectively will typically mean there’s a lost opportunity.
How to Find Dividend-Paying Stocks
Looking at just the S and P 500 for stocks for investing isn’t necessarily going to yield the results you want. You’ll want to review the dividend investing calculations when researching stocks you’re considering. Some other items that you should add to your analysis to find long-term stocks for dividends include:
- Is this company shareholder-friendly? Have they increased their dividends in at least the last three years?
- Is the dividend payout ratio modest?
- Was the CEO hired from within?
- Does the company have a history of revenue and earnings growth?
If your answer is yes to more than half of these questions, then chances are better that it will be a dividend growth stock you can rely on for the future. That’s the type of stocks you want to own.
Tips for Investing in Dividends
Dividend investing is a great way to make passive income in retirement. To reach your goal of living off dividends, you need to invest an adequate amount of money. Here are four tips to follow to make sure you are investing enough below.
Contribute Each Month to Your Dividend Portfolio
A good amount to start with as a contribution is $200 per month. If you can afford to contribute more then do so. What’s most important is automating these contributions so you don’t need to spend time or effort doing it manually each month.
Reinvest Dividend Income
Once you start earning dividends, use them to buy more stock in your portfolio. Avoid using a dividend reinvestment plan which automatically buys shares of a specific stock. That way you can invest it in other stocks in your portfolio that is more beneficial.
Increase your Monthly Contributions Each Year
If you can increase your contributions by 25 percent each year for a decade, you’ll be well on your way to enjoying life on dividends. This is entirely possible to do if you look for ways to increase your income in other ways.
Invest Wisely on Quality Stocks
Don’t try to make investments into too many risky stocks. There are going to be some good and bad stock picks. Just try to have 60 to 80 percent of those stocks as winners.