How to Live Off Dividend Income

The idea of living off dividend income is an attractive one. You can sit back and enjoy life while you collect checks from your investments without having to sell off any investments. But sometimes, investors have misconceptions about dividend income and dividend investing. If dividend investing is so great, why do most professional financial advisors not recommend pure dividend investing strategies for retirement? Why do they offer a more broader investment strategy coupled with a safe withdrawal percentage to fund retirement?

Or can investors do both? Can investors have a broadly diversified retirement portfolio as well as a separate dividend stocks portfolio to collect dividend income? Of course, but that also requires more assets. If your assets are split between a “main” portfolio and a dividend portfolio, then obviously, your dividend portfolio wouldn’t be spitting off as much dividend income as compared to a scenario where your assets are fully allocated to producing dividend income.

But regardless, learning how to live off dividend income is a valuable tool and can instruct your investing and saving approaches as you work toward the retirement phase of life. How much of your investments you allocate towards a dividend investing approach is your personal decision. 

In this how to live off dividend income guide, we’ll discuss the following:

• Understanding dividend income
• How to live off dividend income
  • Safe withdrawal percentage vs. dividend income
  • How big of a dividend portfolio do you need?
  • How much should you be saving now?
• Best dividend stocks for retirement
  • Marks of a good dividend stock
  • Dividend growth stocks
  • ETFs
• Dividend income strategies
• A note about share buybacks

Understanding Dividend Income

What is dividend income? Dividend income refers to the portion of the cash that a company’s earnings that are returned to shareholders as a reward for owning stock in the company. Typically investors are able to get two forms of return from investing in a company: the appreciation of the value of the company and stock and the dividends received while holding the stock. The value appreciation of the stock can only be realized by selling shares of stock while the dividend income can be realized without having to sell the stock. Because of this, many investors view dividend income as a very attractive component of investing.

Important Dates

When holding a stock, there are some important dates you need to know that are very relevant to collecting dividend income. They are the declaration date, the ex-dividend date, the record date and the payable date. The declaration date refers to when the company’s management announces that it will pay an upcoming dividend. For companies with a long history of dividend payments, this is an automatic announcement each quarter (or different periods if the company doesn’t pay quarterly). The ex-dividend date refers to the date in which the stock goes “ex-dividend.” To be eligible to receive the dividend, you must have owned the stock the day before the ex-dividend date. If you buy the stock on or after the ex-dividend date, you will not receive the dividend. The record date refers to when the stock determines the shareholders of record who will receive the dividend, but this can be confusing as it’s referring to the list of shareholders that owned the stock the day before the ex-dividend date (as there is a one or multiple business days of time that passes before official records are noted). Finally the payable date refers to when the cash of the dividend payment itself will hit the account of shareholders of record.

Now that we’ve covered some of the mechanics of owning stocks for the purpose of collecting dividend payments, let’s move on to some other important metrics and methods of analysis that will be important for dividend investors.

Important Metrics and Methods of Analysis

While looking at the actual dividend payment is useful, the more important number to analysis when determining if a stock is a good dividend paying stock is the dividend yield. The dividend yield will tell you your level of return on an ongoing basis with respect to the amount of money you have invested. For example, if the stock you own is trading at $25/share and the quarterly dividend payment is $.50 (or $2.00 annually), then the dividend yield is 8%. You know that you’ll be earning 8% on that investment without even factoring in potential appreciation of the stock itself. You can calculate the yield of a stock by computing: dividend yield = annual dividend / stock price. 

Some investors also like to consider the dividend yield with respect to the amount of cash invested in a certain position. In our example above, if the $25 stock is yielding 8% with its $.50 quarterly dividend, but we purchased the stock originally for $15, then our cash-on-cash dividend yield is much higher. In fact, we can calculate it using the purchase price of $15 by doing $2 / $15 = 13.33%. We’re earning over 13% on the original investment. Most investors, however, don’t look at it this way as regardless of what you purchased the stock at, the relevant number is the current worth as you can sell that investment immediately and take the cash.

By understanding how dividend yield is calculated, we can also see that dividend yield will go down as a stock price increases. So, as a stock appreciates, investing new money into that stock will mean you’re going to get a lower cash-on-cash dividend yield on that new money. On the flipside, if a stock is temporarily depressed (and the dividend payments are maintained), you can buy in with new money and essentially lock in a higher cash-on-cash dividend yield.

Now, over many years, typically a well run company will appreciate in value. But these same companies will also raise the dividend amounts over this period of time. By increasing the dividend rate while the company appreciates over time, the management is able to maintain a relatively stable dividend yield. Investors often call these companies dividend growth companies; that is, companies that regularly increase the dividend payments over many years. We’ll talk more on dividend growth companies later in this guide. 

Another important metric to understand is the dividend payout ratio. This will be a crucial metric to analyze when selecting dividend stocks and attempting to live off dividends. The payout ratio tells us how sustainable a dividend might be. Simply put the dividend payout ratio is calculated as follows: Dividend payout ratio = dividends paid / net income. If a company earned $100 million last year and paid out $75 million in dividends, then the dividend payout ratio for that company would be 75%.

A single dividend payout ratio number rarely tells us anything useful. It’s better to analyze the changes in the dividend payout ratio over time as the company operates, pays dividends and possibly increases dividends. Analyzing such numbers over time will tell a better story than a single year. As you do so, you’ll often notice some outlier years where maybe the dividend payout ratio is much higher or much lower than other years. This is often due to the fact that earnings values can be impacted by major accounting elements. For instance, a company might take a major one-time charge to the business that drastically decreases earnings for that given time period. If that happens, the dividend payout ratio will go way up since earnings are very depressed.

For example, from our analysis of the Ford dividend, you can see how the Ford dividend payout ratio has fluctuated a good bit in recent years:

Because of how earnings (and EPS) can be manipulated based on various accounting events or techniques, some investors prefer to utilize free cash flow when looking at the dividend payout ratio. Some investors believe that how much cash coming into the company might be a better way to measure the sustainability of a dividend than what the stated earnings are. If you’re analyzing stocks for the purpose of living off dividend income, you might want to take the more conservative approach where you utilize cash flow for determining dividend sustainability.

Taxation

As with any investing, taxation must be considered. If you’re holding stocks in a taxable account (likely the case if you’re considering how to live off dividend income) then how dividends are taxed is important. 

Ordinary dividends (which are the types of dividends we’re discussing) are taxed at normal income tax levels. So, you’ll pay the tax rate on your dividend income that you pay for any income you’re receiving. 

Because you pay taxes on your dividend income, it is important to be thoughtful about how you set up your investments depending on the stage of life you are in. If you’re a retiree wanting to live off dividend income, then you’re simply going to pay taxes on the dividend income as you would any income. Since the average retiree doesn’t have high income, these taxation levels are relatively low. 

If you’re a high income earner years away from retirement and do not need the dividend income to live off of, then you might want to be strategic about dividend income. If you have multiple investment accounts, say a IRA, a 401(k) and a taxable equities account, it can be useful to have most of your dividend generating stocks (or bonds for that matter) in your tax-sheltered accounts such as the IRA and the 401(k). It is a common strategy for investors to put investment vehicles that are generating cash payments such as bonds of heavy dividend paying stocks into tax-sheltered accounts and the investment vehicles that aren’t generating ongoing cash payments in the non-tax-sheltered accounts.

Dividend Reinvestment

Another important element of dividend investing is dividend reinvestment. Most major brokerages now let you enable automatic dividend reinvestment for your holdings which means when the stock pays out a dividend, it will automatically use that cash to buy more shares in that stock (even if it’s only enough cash to get a fraction of a share). This in essence lets you use dividends to further your compounding returns on the investment. 

Now obviously dividend reinvestment doesn’t necessarily go with the idea of living off dividend income since if you’re living off the income, you will take the cash and spend it on things you need in your day to day lifestyle. But for those of us not yet ready to retire, dividend reinvestment can be a useful tool for building up the investments to maximize future dividend income when we plan to need it to fund our lifestyles. 

Many companies used to (and still do) offer direct share purchase plans where you can regularly buy stock in a company and automatically reinvest the dividends in the company. In the past this was a very useful way to accumulate shares in a company at the lowest cost possible. With today’s brokerage environment where many online brokers such as Charles Schwab don’t even charge trading commissions and offer auto dividend reinvestment, these direct share purchase plans aren’t as relevant. 

Note that when you do dividend reinvestment in a taxable account, you’ll be required to pay taxes on those dividends you received even if you reinvested them automatically. Most brokerages will provide the necessary documentation for you to use at tax time.

How to Live Off Dividend Income

Learning how to live off dividend income requires a few key things. First, you need to understand how dividends work which is what we outlined in the above section. Next, you need to map out your projected expenses and income from dividends and make sure that your dividend income is sufficient to fund your desired lifestyle. Before we get into the area of ensuring you have enough assets to fund your lifestyle via dividend income, let’s first discuss the idea of safe withdrawal percentage vs. dividend income.

Safe Withdrawal Percentage vs. Dividend Income

Safe withdrawal percentage is a different way of funding your lifestyle from an investment portfolio. It’s also a more common way and a typical way that investment advisers discuss retirement investing and funding. Safe withdrawal percentage refers to the amount of money you can extract or withdraw from your investments each year while minimizing the risk of running out of money before you die.

Probably the most commonly cited safe withdrawal percentage out there is 4%. You’ll hear about the 4% rule sometimes. It’s a common view that if you keep your withdrawals to no more than 4% per year, then you won’t run out of money. The idea here is that if you’re withdrawing 4% a year, and your investments are gaining something like 5-6%, then you’re in a safe zone of risk. This is a relatively decent guideline, but there are risks to this line of thinking (you can read much more about this subject by clicking here).

So what about safe withdrawal percentage vs. dividend income? Neither is better or worse necessarily, but it’s a different approach to drawing income on your investment portfolio. What exactly are the differences? Let’s outline them here:

• Safe withdrawal percentage assumes some selling of assets in order to obtain cash to fund lifestyle whereas dividend income is based on strictly dividend income rather than selling shares of stock or other investments.
• The safe withdrawal percentage approach typically means having a broad diversified asset allocation (stocks, bonds, etc.) that is funding your retirement. Some of these stocks are high dividend stocks, and some are not. Dividend income approach is typically focused on high dividend stocks only. 
• It’s possible to do a combination of the two strategies where perhaps a retiree is banking on dividend income from a great dividend portfolio, but also integrating some standard withdrawals from the portfolio as well.

The path to living off dividend income

To live off dividend income, you need a large asset base. To get a large asset base, you need a disciplined saving and investing strategy many years before you attempt to live off the dividend income. To get to the point where you can live off dividends, you need to execute the following over a long-term time horizon:

• Disciplined lifestyle where you have money left over that you can regularly save. By starting early and saving as much as possible as early as possible, it can literally be the difference in hundreds of thousands of dollars or even a million dollars at the time of your retirement. Limit your expenses on the big ticket items such as home and auto. Sacrifice a bit of lifestyle in these areas to fund your investments. You’ll thank yourself later.
• Regularly investing your cash into a well thought out portfolio of investments regardless of market activity. By systematically investing on a regular interval, you will take advantage of dollar cost averaging.
• Reinvest all dividends to maximize compounding and growth of your investment portfolio.

How big of a dividend portfolio do you need?

Let’s look at what kind of dividend portfolio you will need to generate various amounts of dividend income. Obviously living off dividend income requires mapping out the lifestyle portion of the equation as well, but we aren’t going to go into detail on that side of it. Obviously the lower your lifestyle and expenses, the easier it will be to live off dividend income. 

What kind of dividend yield should you assume? When projecting retirement scenarios, it could be a good idea to go with a more conservative estimate, but many investors like to assume a 3% dividend yield. With a well constructed dividend portfolio, that shouldn’t be difficult to achieve. Here are a number of potential dividend income levels based on both portfolio size and dividend yield:

Now that we have look at the amount of dividend income that various portfolios can generate, it’s time to look at how we can reach these portfolio sizes.

How much should you be saving now?

Through saving and investing over time, investors can build a strong dividend income generating portfolio. Let’s break this down into regular saving and investing intervals to provide some examples on how investors can build such a portfolio.

For each of these examples, we’ll assume a 3% dividend yield and a 6% annual growth in investments via appreciation.

Example #1: Save and invest $250 per month to your investments

In the below example, by contributing $250 per month over the course of 30 years, the investor ends with a portfolio value of just under $500,000 and dividend income of over $13,000 per year.

Example #2: Save and invest $500 per month to your investments

In the below example, by contributing $500 per month over the course of 30 years, the investor ends with a portfolio value of just under $1,000,000 and dividend income of over $26,000 per year.

Example #3: Save and invest $1,000 per month to your investments

In the below example, by contributing $1,000 per month over the course of 30 years, the investor ends with a portfolio value of just under $2,000,000 and dividend income of over $53,000 per year.

Example #4: Start investing $200 per month to your investments, then increase your monthly contribution by $25 each year

In the below example, we assume a contribution starting at $200 per month and then increasing by $25 each year thereafter. After 30 years of this saving and investing activity, the investor ends with a portfolio value of just over $800,000 and dividend income of over $22,000 per year.

Best Dividend Stocks for Retirement

When constructing your dividend income portfolio, there are some specific types of stocks you should be looking for. Having a diversified mix of companies that have sustainable, reliable and growing dividends will be the basis for a strong dividend portfolio that can provide reliable income during retirement. So, how do you find the best dividend stocks for retirement?

Marks of a Good Dividend Stock

Dividend investors often discuss common characteristics of strong dividend stocks. The following are some common marks of a good dividend stock:

• Financial health: A strong and reliable dividend growth stock will have very sound financial health. This can be often analyzed by looking at the dividend payout ratio, cash flow levels and levels of debt.
• Dividend history: Does management have a history of steady dividend payments? Does management attempt to grow the dividend on an annual or regular basis? Strong dividend stocks will have a solid history of dividend payments.
• Management stability: How long has leadership been in place? If a new CEO has taken over, is the CEO an outsider or someone promoted from within? On occasion, an outsider coming in to take over might lead to a shift in dividend strategy from the company’s management.
• Shareholder friendly: Is management consistent on valuing shareholders with respect to returning capital via dividends? It’s worth noting that share buybacks have become a common way of management “returning” value to shareholders. Buybacks have a bit more criticism and controversy around them when compared to dividends. The last section of this guide discusses share buybacks.
• Revenue and earnings growth: Does the company have a proven track record of growing revenues and earnings? Is the company in a dying industry? This last question is an interesting one as a popular dividend stock is Philip Morris. Tobacco is arguably a dying industry, but the company has management to keep steady and growing dividends for many years even while tobacco use declines. Still, the industry context is something to consider when selecting dividend stocks.

Dividend Growth Investing / Stocks with Increasing Dividends

One of the reasons I like the dividend growth investing approach is that it forces the investor to be committed to long-term investing. The investor’s mindset isn’t just on short-term returns and dividends collected this year, but the investor has an eye on where these dividends can be many years from now.

How do you find the best stocks with increasing dividends? One place to start is with the list known as the Dividend Aristocrats. The Dividend Aristocrats are stocks that have increased their dividends for at least 25 consecutive years. An important note is that the Dividend Aristocrats are S&P 500 stocks and span all sectors of the index meaning you have a well-diversified list.

You can view the list of Dividend Aristocrats below. You can also view and duplicate this publicly accessible Google doc by clicking here.

Yield Traps

Dividend yield traps refer to dividend paying stocks that have extremely high dividend yields. These stocks might be paying something like 6%-8% and look quite attractive at first glance. What a yield! But often times these high yielding stocks might be a red flag for some problems underneath. For instance, if you recall the formula for calculating dividend yield, the share price is a major component. If something causes the share price for a stock to plummet in a very short period of time, the dividend yield might shoot up quite a bit. Typically if the share price plummets, then there is something about the fundamentals of the business that is giving investors pause about the stock. If there are issues with the business, then there’s a decent chance that the dividend might be cut in the future as well as the company attempts to reduce its outgoing cash.

Prudent investors will attempt to analyze the situation and determine if there is truly an issue with the business or if maybe there is just a one-time issue that caused weakness in the stock. If the former, then you likely don’t want to buy this as a dividend stock, but if the latter, then you might be able to get a good long-term stock at an attractive price (while locking in an attractive yield). Analyze the income of the company. Is the company paying out more in dividends than it is taking in via income? What’s the balance sheet look like? Is the company running low on cash? These can be red flags to indicate if you’re looking at a potential yield trap.

What about ETFs?

If you’re having trouble picking dividend paying stocks and instead want to just get a basket of dividend stocks for maximum diversification, then there are some nice ETF options available.

For instance the Schwab US Dividend Equity ETF (SCHD) attempts to track the Dow Jones US Dividend 100 Index. This index is a broad basket of high dividend paying US companies spread over a number of sectors. You can eliminate the single stock picking risk by opting to go with an ETF approach such as the SCHD.

Dividend Income Strategies

Let’s get back to living off dividend income. How should you arrange your dividend portfolio? There are differing opinions on this. Some like to arrange their portfolio to ensure dividend payouts on an evenly basis to coincide with when they will actually need the money. Others don’t concern themselves with attempting such a structured payout calendar, but instead just let the dividends collect in their brokerage account, then do regular withdrawals of cash to fund lifestyle. It mostly comes down to personal preference, as there’s no wrong way to do it.

Monthly dividends

Some retirees love the idea of getting regular monthly dividends coming into their account. While this might sound somewhat complicated, it’s actually more simple than you might think. For instance, most companies pay a quarterly dividend, or four times per year. As such, you really only need three dividend paying stocks to achieve a monthly dividend collection (note that most investment professionals strongly encourage not having your investment portfolio only spread out over only three companies as this wouldn’t be considered diversified enough). For example purposes, let’s consider company A, B and C. Each pays a quarterly dividend at different times during the year. You could arrange monthly dividends as follows:

• Company A dividends paid: January, April, July, October
• Company B dividends paid: February, May, August, November
• Company C dividends paid: March, June, September, December

If you invest in a broader range of dividend paying stocks, say 25 of the Dividend Aristocrats outlined above, then accomplishing regular (even monthly) dividend payments is relatively easy.

Dividend capture strategy

The dividend capture strategy is a unique (and somewhat controversial) approach to living off dividend income. This strategy aims to buy and sell stocks at a relatively high frequency in order to capture as many dividend payments as possible. In essence, the investor will do something along these lines:

• Day 1: Buy stock A the day before stock A’s ex-dividend date.
• Day 2: Sell stock A. Buy stock B the day before stock B’s ex-dividend date.
• Day 3: Sell stock B. Buy stock C the day before stock C’s ex-dividend date.
• Etc.

Pros of the dividend capture strategy:

• You can collect a lot of dividends
• Because of the competition in online brokerages recently, trading commissions are essentially zero which was a major deterrent to such a strategy in the past.

Cons of the dividend capture strategy:

• It’s time consuming.
• In theory, this shouldn’t even work since the share price has the value of the dividend payment deducted it from the stock once the stock goes ex-dividend. It doesn’t always work out perfectly this way, but in general, whatever value you’re adding via the dividend, you’re losing in the share price (which you then have to sell).

Unless you’re bored, I’d generally recommend against the dividend capture strategy for individuals looking to live off dividend income.

A Note About Share Buybacks

Buybacks have become increasingly a part of the investing world in recent years especially with low interest rates and a good economy. The combination of lower debt costs and an abundance of cash from operations has led to many boards of the world’s biggest companies to buy back tremendous amounts of their own stock. Note that this is one form of shareholder return, but not all shareholders are happy about this trend.

Let’s start with the positive. By buying back shares of stock, the company is able to reduce the amount of outstanding shares and therefore help boost overall earnings per share (EPS) and continue to increase dividend payouts per share as well (since there are fewer shares to pay based on). Also, this is a way to return value to shareholders without shareholders incurring a taxable event.

On the negative side, share buyback critics sometimes point out that share buybacks can be used by management to mask the dilution occurring by giving shares to executives. In essence, the company is using cash to buy back shares that are being granted to the executives. At worst, it’s a way to mask the overpaying of executives.

Perhaps the more common and reasonable criticism is that share buybacks rely on management’s ability to time the stock market. Quite often, the company is using cash to buy back shares at higher prices than perhaps they should be. There are many examples in recent history of companies spending billions on share buybacks to only have the share price go much lower in years later meaning they essentially bought many shares at higher prices than are currently supported.

Dividend investors tend to prefer increased dividends rather than share buybacks. Rather than relying on the management of the company to buy back stock at the best time, they can instead just return the cash to shareholders and let shareholders determine what to do themselves with the cash.

Frequently Asked Questions

How much money do you need to live off dividends?

To live off dividends, how much money you need will be determined by the cost of your lifestyle, the size of your investment portfolio and the dividend yield of the portfolio. You can determine the annual dividend income of an investment portfolio by calculating: Dividend Income = Dividend Yield * Portfolio Size. For example, a $1 million portfolio with a 3% dividend yield will result in $30,000 in dividend income per year.

Are dividends a good source of income?

Dividends can be a great source of income especially when investing in proven, stable companies with a long history of maintaining and increasing dividend payouts over time. Dividend Aristocrats refer to 50+ S&P 500 companies that have increased dividends for at least 25 consecutive years. This stable and increasing payout each year can be a great source of income that is mostly unaffected by the ups and downs of the stock market.

How long do you have to own a stock to get a dividend?

You only have to own the stock for a single day to get the dividend. You must own the stock on the day before the ex-dividend date. Once the stock goes “ex-dividend” then you’ll be the shareholder of record for when the dividend is to be paid. You can sell the stock at any time on or after the ex-dividend date, and you’ll receive the dividend.

What is the safest investment for retirees?

Retirees should work with an investment professional to develop a safe and well-designed investment portfolio. The safest investment is cash, but you won’t earn a return on that. Retirees can balance risk and return through a conservative portfolio of cash-based assets, bonds and stocks.