Generating income in retirement has been one of the trickier propositions over the last decade. With interest rates extremely low since the last financial crisis in 2008, the search for yield is more complicated than it had been previously.
You can't simply stick your money into a bond fund and hope for the best. In fact, with bond yields losing out to inflation, a bond-heavy portfolio is likely to lose purchasing power over time and deliver negative real returns.
Luckily, there are alternatives. Here, we'll go through five easy steps to generate cash flow in retirement while employing a bit of creativity along the way.
1. Amass starting capital
Unless you're borrowing on margin (which I won't recommend here), you'll need to save up a reasonable capital base before you're able to generate a sizable and sustainable stream of income. The basic calculation for annual dividend payments is:
(Starting balance x Investment Dividend Yield)/12 = Monthly Dividends
For example: Assume a starting balance of $120,000 and multiply that by 0.03 (for an annual dividend yield of 3%), and you get $3,600 a year. Divide that by 12 to get a monthly dividend of $300. This is an oversimplified example that can vary based on the underlying investment and the account in which you choose to hold the investment.
2. Go for ETFs
Exchange traded funds (ETFs) are one of the best vehicles for long-term investing: They're diversified, usually have low costs, and are tax-efficient and easy to trade. Many high-dividend ETFs exist to support investors who want income; that is, they're less concerned with capital appreciation than with cash distributions. ETFs also remove the burden of picking individual stocks, which can be time-consuming and inefficient.
But while we're at it, why not give yourself the best chance for total returns as well? Even if you're developing a portfolio centered on income, it's sensible to invest in a basket of companies that have a demonstrated track record of price growth as well as a high probability of future growth. Some great balanced options are below:
SCHD (NYSEMKT: SCHD)
Schwab U.S. Dividend Equity ETF
VYM (NYSEMKT: VYM)
Vanguard High Dividend ETF
SDY (NYSEMKT: SDY)
SPDR S&P Dividend ETF
NOBL (NYSEMKT: NOBL)
ProShares S&P Dividend Aristocrats ETF
VIG (NYSEMKT: VIG)
Vanguard Dividend Appreciation ETF
3. Tax optimize
Taxes are incredibly resilient. You'll end up giving away a solid chunk of your dividend income to the IRS if you carelessly plan your dividend portfolio. Keep the following tax tips in mind when you allocate your dividend-generating investments:
If you keep dividend-generating investments in a tax-deferred account like a 401(k) or a traditional IRA, no tax is charged upon receipt of dividends. Only when you withdraw money are you taxed.
Dividends in a taxable account will be taxed every time they are paid. To avoid this, consider holding investments that rely primarily on growth (like total stock market funds) in your taxable account and investments that rely primarily on income (bond funds or high-yielding ETFs) in your tax-deferred accounts.
The longer you hold your investments, the more tax-efficient they'll be. After a year, income generated by most investments (except for a number of exceptions) will be considered “qualified” and eligible for preferential taxation. Qualified dividends receive long-term capital gains tax treatment, which can save you a ton in taxes under current law — and probably even more once new tax regimes are passed.
Remember that most investment strategies tend to perform best when you commit to them over time. Trading in and out of positions based on recent performance rarely ever leads to long-term success. Once you've decided on an income strategy, your best bet is to set it up, leave it alone, and allow it to serve its intended purpose.
By reinvesting your dividends, you'll continuously increase your dividend receipts over time. When you reinvest dividends, you take the current month's dividend to buy more shares. This means that when the next dividend payment is due, you'll receive more than you did the last time as you now own more of the underlying investment. Reinvesting dividends (assuming you don't need the money to cover expenses) is a zero-effort way to boost your cash flow.
Income is only half the story
It's a reasonable guess that people want higher balances in their investment accounts. Remember that dividends (cash distributions) are one form of investment income, but not the only form. Capital appreciation (capital gains) is at least as important as dividend payout. While you're certainly not wrong to want high dividends, keep an eye on the total return of your portfolio for best results.
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Sam Swenson, CFA, CPA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends ProShares S&P 500 Aristocrats ETF, Vanguard Dividend Appreciation ETF, and Vanguard High Dividend Yield ETF. The Motley Fool has a disclosure policy.