When you’re living that clock-in, clock-out life, passive income can sound like a dream come true: all you do is set up your investment portfolio and watch those fat stacks roll in.
But of course, no investment is risk-free, and it’s definitely not that simple. Earning money on the stock market takes patience, practice, and more than a little bit of learning… and that’s just when it comes to regular capital gains.
For many of us, the primary purpose of investing is to fund our far away retirements through appreciation earnings, but dividend income might create a steady(ish) stream of cash.
In this article, we’re going to talk all about dividend income: What it is, how it’s taxed, and tips for setting up your investment portfolio to potentially maximize dividend earnings.
What Is Dividend Income?
To understand how you might be able to use dividend income to supplement (or comprise) your earnings, we first have to cover what exactly dividend income is.
Dividends are cash payments meted out to stockholders at regular intervals, simply for owning shares of the company.
In other words, dividend income is distinct from the capital gains earned by selling off stocks or other assets and profiting off their appreciation in value.
You don’t need to sell an asset to earn dividends from it; in fact, if you did, you’d no longer be eligible to collect its dividends.
Dividends are paid from company profit—the same well of money used to reinvest in company growth, pay down company debts, or to otherwise increase the value of the business.
Dividends are portions of that profit paid as cash to shareholders, and may also be offered on a monthly or annual basis instead of once per quarter.
Some companies might also pay out “special dividends,” or one-time payments, often after an event or performance streak that leads to an excess of cash in the company coffers.
How Much Do Dividends Pay?
Dividends are calculated by the company based on available profits and may vary over time. The amount of dividend payout is declared on the dividend announcement date, and must be approved by shareholder vote before it can be paid out.
Because the amount is variable, dividends aren’t a reliable income source. That said, looking into key metrics such as dividend yield, dividend growth rate, and dividend payout ratio may prove helpful. (More on all that in just a bit!)
What Can Dividend Income Be Used For?
Dividend income is just that: income. And while many working-age earners choose to reinvest dividends to increase their passive earnings, it can be used for day-to-day life stuff, too.
Dividend income is a valuable way to supplement earnings for retirees, who may not have many sources of money to draw from. Dividend income represents an additional cash flow that can make living on a fixed income more flexible, comfortable, and sustainable.
Is it Possible to Live off Dividend Income?
Earning more money by simply putting your own money in the stock market may sound like a pretty darn attractive life plan. But is it actually possible to live solely off dividend income?
Well, the answer to this question obviously depends on your lifestyle and spending habits.
One super-frugal investor might be able to scrape by on $3,000 a year and consider themselves happy, while another might want the creature comforts afforded by higher earnings.
But even if you’re scrappy and willing to live on modest means, it’ll potentially take time to create the kind of portfolio you’ll need to make your living on dividend income alone.
After all, dividend payouts directly depend on a company’s profits, and thus aren’t always dependable. That means you’ll probably need to flesh out a diversified portfolio of dividend-paying assets in order to create enough income to sustain even a low cost of living.
That’s why many investors who are thinking seriously about living off dividend income are retirees: they’ve had years to curate and fund a robust portfolio that can support them on dividends alone.
Even in retirement, it’s a good idea to have several income streams to rely on, such as capital gains earnings from retirement accounts, Social Security benefits, or a pension.
That said, if you’re hoping to earn some income on dividends, whether in retirement or your working life, it’s important to invest with that goal in mind from the start.
Investing for Dividend Income
Earning dividend income involves investing in stocks that pay dividends—sounds like common sense, but it’s easy for beginning investors to overlook. Not all companies pay dividends to their shareholders, and even among those that do, amounts can vary considerably.
Therefore, it may be worth focusing both on companies that offer investors the opportunity to earn dividend payments now, and those that may offer dividend amounts that increase year by year.
This may mean striking a balance between mature, currently successful companies and newer ones experiencing dividend growth—meaning their dividend payouts tend to increase every year.
Dividend growth is a powerful tool in the pocket of any investor, whether or not they hope to live off dividend income alone.
It offers shareholders the potential for exponential returns, especially when dividends are reinvested into the investment for longer-term gain. Dividend growth has also historically outpaced inflation .
So how can you tell if a company could be worth adding to your dividend-earning portfolio—keeping in mind that, as with all investments, this strategy comes with risk?
Dividend Investing Calculations and Metrics
It’s a good idea to take the time to research a potential investment before you sink your money into it. From learning basic stock market terms to figuring out the best time to buy and sell specific stocks, a well-informed investor is more likely to be a successful one.
For investors specifically interested in earning dividend income, here are some of the valuation metrics to keep an eye on.
Dividend yield is a measurement that’s calculated by dividing a company’s annual dividend payout by the price of its shares. Thus, it offers investors an opportunity to learn approximately how much of a dividend return they might expect to see on their investment.
A company with a high dividend yield, however, is generally a more mature company—one that has enough profits to offer its shareholders a decent yield rate, but which might not be seeing very much growth and expansion at this point in its life cycle.
On the other hand, a high yield could be a sign of a falling stock price that could indicate troubles at the company such as impending bankruptcy. Thus, it’s also important to consider another valuation metric: dividend growth rate.
Dividend Growth Rate
The dividend growth rate measures how a company’s dividend payouts change over time. It’s expressed as a percentage, and refers to the amount of growth in dividend amount as compared to the year prior.
Although it won’t tell you as much about how much you might stand to earn from a given company in dividend income, dividend growth rate is an important metric to consider. It can give you an idea of the company’s growth potential, and may help you make decisions that might increase your total dividend income in the long term.
Dividend Payout Ratio
Dividend payout ratio is calculated by dividing the total amount of dividends paid to shareholders by a company’s net income. Thus, it can give investors a feel for what percentage of a company’s profits are being paid out to shareholders as dividends.
While it may seem like a higher dividend payout ratio is better for the investor, that’s not always the case. If a company is hemorrhaging all of its profits and not reinvesting anything in growth and development, it may not be able to sustain its good performance long term.
On the other hand, a low dividend payout ratio may indicate a company hasn’t yet matured enough to funnel much of its earnings into dividends… which might mean the company still has lots of room for growth.
Thus, companies with low payout ratios may also stand to see more appreciation over time, giving investors the opportunity to earn gains in share value as well as dividend income.
Building a Healthy Investment Portfolio
If you’re a beginning investor looking to create a healthy, gainful portfolio, a lot of the same advice applies whether or not you’re focused specifically on dividend earnings.
Since all investments come with risk, a diverse portfolio can help you mitigate a single company or industry’s blips in performance. And you may want to rebalance your portfolio periodically to make sure you’re not leaning too heavily on one asset or another.
Diversifying Your Investments
Especially when it comes to dividend income, diversifying your investment portfolio is critical: Even companies with high historical dividend yields might encounter a period of poor performance, and some companies with the highest growth potential may not be paying out an appreciable dividend right now.
By adding a wide variety of companies, from different sectors and categories, to your portfolio, you’ll have a better chance of riding out volatility without seeing major losses.
Diversifying your dividend-paying assets can also help you earn the most dividend benefits, potentially maximizing your returns over time.
Continuing to Fund Your Account
They say you’ve got to spend money to make money… and when it comes to investing, that’s true. You can’t earn dividends (or any other kind of investment-based income) without actually purchasing some investments!
One way to potentially get the most out of your portfolio is to continue to fund the account as often as possible. With this strategy, you’re constantly adding to the base funds that will have the chance to grow with both appreciation and through dividend income.
There are many ways to automate this process to make it simple and painless, like dollar cost averaging. In many cases, you can simply set up an auto-draft to have a portion of each paycheck contributed to your investment account. (Just don’t forget to actually allocate those funds to stocks, bonds and other assets!)
Ready to Get Started on Your Investment Journey?
From creating a passive living off dividend income to funding your future retirement, investing can be one of the most powerful tools around to help you get your money right.
SoFi offers both active and automated investing products to help you get started—our app makes investing simple and stress-free, right in the palm of your hand.
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