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Building a Sustainable Income Stream: How to Live off of Dividends in Retirement

Living off of dividends during retirement is a concept that involves building a portfolio of dividend-paying stocks that generates enough income to cover your living expenses. The idea is to invest in companies that have a history of consistently paying dividends and have a strong likelihood of continuing to do so in the future. This income can be used to supplement other sources of retirement income, such as pensions, social security, or rental properties.

One of the main benefits of living off of dividends is that it can provide a consistent and predictable income stream, regardless of market fluctuations. Dividends are typically paid out on a regular schedule, such as quarterly, which can help to stabilize your retirement income. Additionally, many dividend-paying stocks also have the potential for capital appreciation, which can increase your overall returns over time. In this article we'll take a look at what it takes to build a passive income portfolio from dividends that you can use to live off of before or during retirement.


This article is a supplement to my Ultimate Dividend Investing Guide. If your look to start you dividend investing journey, I've spent 100s of hours compiling as much as possible in one place!


 

Table of Contents

The 4% Withdrawal Rule VS Living Off Dividends

The Pros and Cons of relying on dividends as a primary source of income

Tips for successfully living off of dividends during retirement

Determining how much income is needed to live off of dividends

The importance of compound annual growth rate (CAGR) and living off dividends

Understanding the impact of taxes on dividends

The importance of diversifying your dividend portfolio

Conclusion

 


The 4% Withdrawal Rule VS Living Off Dividends

I covered the 4% withdrawal rule in depth previously. Take a look here if you want to learn more about using the 4% rule during retirement.


A summary of the withdrawal rule is that you would sell 4% of your portfolio to use as your income as retirement. The following years you would adjust this amount by inflation to maintain your standard of living.


The downside of using the 4% rule is that it requires you to sell shares from within your portfolio to use as your retirement income. Living off dividend income doesn't require you to sell any shares.


What are dividends?

Remember, dividends are company profits paid directly to shareholders (you!) for owning a stock. You get paid in cash just for being an owner of a share! The rough math is:


# of shares owned X Annual Dividend amount = Income Generated


You can download my FREE Dividend Calculator if you want a SUPER easy way to calculate dividends!


You can build your passive dividend portfolio and NEVER have to sell a share. Your portfolio will continue to enjoy compound interest all while your dividends also continue to grow. Lastly, since you never sell any of your assets you can pass these on to family or children to build generational wealth!


Benefits and drawbacks of relying on dividends as a primary source of income


Dividends, just like any investment or retirement strategy, come with both pros and cons. Let's take a look at some of the benefits and some of the drawbacks to dividend investing.


Benefits of relying on dividends during retirement:


  • Consistent and predictable income stream: Dividends are typically paid out on a regular schedule, which can provide a stable source of income for retirees.

  • Potential for capital appreciation: Many dividend-paying stocks also have the potential for capital appreciation, which can increase your overall returns over time.

  • Diversification: Dividend-paying stocks can provide a way to diversify your portfolio, which can help to minimize risk.

  • Inflation protection: Dividend-paying stocks have the potential to increase their dividends over time, which can help to protect against inflation.

  • Never selling shares: Dividends pay you for owning shares, allowing you to live off dividend income instead of the money from selling shares. This benefit keeps your portfolio intact.


Drawbacks of relying on dividends during retirement:


  • No guarantees: Dividends are not guaranteed and can be reduced or eliminated at any time, which can impact your income. We'll cover ways to decrease the risk of this affecting you during retirement.

  • Limited growth potential: Dividend-paying stocks tend to be more mature companies and may not have as much potential for growth as non-dividend-paying stocks. This is not always true but in general dividend stocks will not appreciate the same as growth stocks.

  • Risk: Relying solely on dividends for your retirement income can expose you to more risk, as you are putting all your eggs in one basket.

  • Tax implications: Dividends are taxed differently than other forms of income, and this needs to be factored in while considering living off dividends.

  • Limited income: Relying solely on dividends as a source of income may not be sufficient to cover all your living expenses in retirement.


It's important to keep in mind that relying on dividends as a primary source of income during retirement can have both pros and cons. It's important to have a comprehensive financial plan in place and to regularly monitor and adjust your portfolio as needed. Additionally, it's recommended to seek professional advice to make sure you are on the right track.


Tips for successfully living off of dividends during retirement


  1. Start early: The earlier you start investing in dividend-paying stocks, the more time you have to build a portfolio that generates enough income to cover your living expenses.

  2. Create a financial plan: Have a clear understanding of your retirement income needs and create a financial plan that outlines how you will achieve them through dividends.

  3. Research and select stocks carefully: Evaluate dividend-paying stocks based on factors such as consistency of dividends, growth potential, and risk. Diversify your portfolio across different sectors and industries.

  4. Reinvest dividends: Consider using a dividend reinvestment plan (DRIP) to automate your dividend investing and maximize returns over time.

  5. Monitor and adjust your portfolio: Regularly review and adjust your portfolio as needed to ensure it remains aligned with your goals and risk tolerance.

  6. Seek professional advice: Consult a financial advisor if you need to. They can help you create a comprehensive financial plan and ensure you are on the right track.

  7. Be aware of the tax implications: Dividends are taxed differently than other forms of income, so it's important to have a good understanding of how taxes may impact your income.

  8. Consider other income-generating strategies: Diversify your income streams and consider other ways to generate income during retirement, such as rental properties or part-time work.

  9. Have a long-term perspective: Remember that living off of dividends during retirement is a long-term strategy that requires patience and discipline.

  10. Have a contingency plan: Have a plan in case dividends are reduced or eliminated, so you can adjust your expenses accordingly.


Determining how much income is needed to live off of dividends


Determining how much income is needed to live off of dividends is an important step in creating a financial plan for living off of dividends during retirement. The amount of income required will depend on several factors, including your current living expenses, desired lifestyle, and projected inflation rate. If you haven't built one yet, now is the time to build a budget. I have both monthly and annual budget templates available to get you started! These will ensure you know how much you are currently spending so you can plan your lifestyle during retirement. A thorough budget is CRITICAL for retirement planning.

Annual Budget Template Preview. Available Here


To start, you should calculate your current living expenses, including housing, food, healthcare, transportation, and any other necessary expenses. You should also factor in any additional expenses you expect to have during retirement, such as travel or hobbies. Next, you should determine your desired lifestyle during retirement, including your plans for travel, entertainment, and any other activities. This will help you to estimate the additional income that you will need to support your desired lifestyle. Finally, you should factor in the projected inflation rate, which is the rate at which the cost of goods and services is expected to rise over time. Inflation can have a significant impact on your retirement income needs, as it reduces the purchasing power of your income.


Once you have determined your current living expenses, desired lifestyle, and projected inflation rate, you can calculate the total income needed to support your retirement. It's important to note that this is a rough estimate, and you should review your calculations regularly and adjust as needed.


Now that you have an estimate of how much you will need to live off dividends, let's take a look at calculating dividend income. This is where dividend yield comes into to play.


What is dividend yield:

Investopedia defines dividend yield as: the dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price.


The formula for dividend yield is:


Annual Dividend Paid / Share Price = Dividend Yield


To calculate the dividend yield for your portfolio you need to calculate the average dividend yield of all of your assets. This is easy if you have one or two but can become more difficult as you add positions but it's important to know. Calculating the average is as easy as adding all of your dividend yields and then dividend that total by the number of assets you have. This assumes that every asset is equally weighted inside your portfolio. In the example each would be 20% of the portfolio. Here's an example:


  1. Asset #1 Dividend Yield = 3.45%

  2. Asset #2 Dividend Yield = 2.67%

  3. Asset #3 Dividend Yield = 4.12%

  4. Asset #4 Dividend Yield = 0.50%

  5. Asset #5 Dividend Yield = 2.89%

The total would be 13.63. Next, we would divide that by five since that's the number of assets in the example. Remember, this ONLY works if all of the positions make up the same percentage in your portfolio! Your brokerage firm might also provide this number for you.


The ANSWER: Our example portfolio has a dividend yield of 2.726%


Income Estimator from TD Ameritrade
Example of TD Ameritrade's Income Estimator showing my portfolio's average dividend yield.

If you are trying to figure out what yield to aim for you can also run calculations off different percentages to see how much you would need to invest to earn your target income. The next formula we can use is the Dividend Income formula:


Annual Income Desired / Dividend Yield = Investment Amount Needed


This formula tells you how much you need invested at your portfolios yield or target yield to earn the desired amount of dividends. Here's an example:


Say we want $72,000 a year or $6,000 a month from dividends during retirement. Using our yield of 2.726% from above the formula would look like this:


72,000 / .0276 = Investment Amount Needed


The ANSWER: Using the information above we would need a portfolio value of $2,608,695 to earn $72,000 a year from our dividends.


Again, using my FREE Dividend calculator, you can do this much easier!


Lastly, I personally aim for an average dividend yield close to 4% to align with the 4% withdrawal rule. This is a personal choice, you can aim higher or lower if you want. Just ensure you understand how this will effect your goal investment total. Also, don't fall victim to YIELD TRAPS! Higher yield doesn't always mean it's the right investment.


The importance of compound annual growth rate (CAGR) and living off dividends


Just like the 4% withdrawal rule you want your dividends to grow over the use. Ultimately, you want your dividends to grow at or faster than inflation. This will ensure your standard of living remains the same throughout retirement. The awesome fact about dividends is that your stock price will hopefully appreciate and the companies will also increase their dividends each year. It's possible for the stock market to fall for year but your dividends to increase. This is called compound annual growth rate or CAGR. This is expressed as a perentage. It could be the one year, three year average, five year average or longer. Inflation averages around 3-4% annually. Remember, that is an average. For example, the 2022 inflation rate was 6.5%. I personally aim to purchase assets that have a dividend CAGR of 5% or higher.


I use FinanceCharts.com as a free resource to research dividend growth and dividend CAGR. It's a great chart that has a lot of technical information. I encourage you to check it out! Below we will take a look a COSTCO Stock ($COST) and see how their growth would play out in an example portfolio.


COSTCO  ($COST) Dividend Information
FinanceCharts.com's $COST Metrics

Above is the metrics from FinanceCharts.com on Costco as of January 20 2023. We can extract the follow data:


Costco Dividend Yield: 0.73%

Costco CAGR TTM*: 13.72%

Costco 3Y Avg CAGR: 11.50%

Costco 5Y Avg CAGR: 12.48%

*TTM means trailing twelve months or what the growth was over the last 12 months.


Let's set up an example where we only hold Costco stock:


Portfolio Value: $3,000,000

Annual Dividends: $21,300 based on 0.073% dividend yield.

Dividend CAGR: 12.48%


Costco's dividend yield may be low but their dividend growth rate is high, averaging 12.48% over the last five years. That's much higher than inflation, meaning you standard of living would actually increase if Costco maintains their dividend growth rate. Remember, the growth rate is how much your dividend income will grow EVEN if you add ZERO additional funds to yuor account. This is the growth is all organic growth.


Let's see how a 12.48% growth rate works out for you during retirement:

Year

Start of Year Dividends

End of Year Dividends

Year 1

$21,300

$23,958.24

Year 2

$23,958.24

$26,948.23

Year 3

$26,948.23

$30,311.37

Year 4

$30,311.37

$34,094.23

Year 5

$34,094.23

$38,349.19

Year 6

$38,349.19

$43,135.16

Year 7

$43,135.16

$48,518.43

Year 8

$48,518.43

$54,573.53

Year 9

$54,573.53

$61,384.31

Year 10

$61,384.31

$69,045.07

As you can see from the example above, your Costco Dividend Income grew from $21,300 or $1,775 a month to $69,045 or $5,753 in just 10 years. It's important to note that Costco has a high dividend growth rate. As more conservative 3-4% growth rate wouldn't show such a drastic increase. Remember, the goal is for your portfolio's dividend growth rate to match or beat inflation. This allows your to maintain a standard of living during retirement.


Understanding the impact of taxes on dividends


Understanding the impact of taxes on dividends is important for anyone who is considering living off of dividends during retirement. Dividends are taxed differently than other forms of investment income, and it's important to have a good understanding of how taxes may impact your income.


In the United States, dividends are considered qualified if they are paid by domestic corporations or qualified foreign corporations. Qualified dividends are taxed at a lower rate than ordinary income. For the tax year 2021, the tax rate for qualified dividends ranges from 0% to 20%, depending on the taxpayer's income level. Qualified are taxed at the same rate as Long Term Capital Gains for federal income tax purposes. Using the information below, you could earn up $83,350 (Married, filing jointly) from dividends and not have to pay any federal taxes if they were all qualified dividends.



On the other hand, non-qualified dividends or ordinary dividends are taxed at the same rate as ordinary income, which ranges from 10% to 37% for the tax year 2021. It's also important to note that dividends are subject to state income taxes as well. Some states do not tax dividends at all, while others have taxes that are similar to federal taxes. Ordinary dividends are taxed at your income tax rate for federal income tax purposes.


Investing in qualified dividends can help you retain the most dividend income for use during retirement. For US investors, I highly recommend investing in qualified dividends for use in retirement.


Another thing to keep in mind is that as a retiree, you may be eligible for certain deductions and credits that can help to reduce your tax liability. For example, if you are over the age of 70 1/2 you are required to take Required Minimum Distributions (RMDs) from your retirement accounts, and these distributions may be taxed differently.

It's important to consult a tax professional to understand the tax implications of living off of dividends and to ensure that you are taking advantage of all available deductions and credits. Taxes can have a significant impact on your income from dividends and it's important to understand how dividends are taxed and to plan accordingly. It's also important to regularly review your tax situation and to consult with a tax professional for guidance.


The importance of diversifying your dividend portfolio


Diversifying your dividend portfolio is essential for anyone who is living off of dividends during retirement. Diversification helps to minimize risk by spreading your investments across different sectors and industries, so that the performance of any one stock or sector does not have a disproportionate impact on your overall portfolio. Imagine you only invest in one dividend paying company and you we're receiving $50,000 a year from them in dividends. If company reduces their dividend by 25%, your income just dropped to $37,500. Even worse, what if they eliminate their dividend? Now your retirement income would be ZERO. Even strong companies have done this. For example, Disney eliminated their dividend entirely during COVID. Diversification help you spread your bets so if one of your positions reduces or eliminates their dividend the other will offset the loss with their growth.


When diversifying your dividend portfolio, you should aim to invest in a mix of stocks from different sectors, such as consumer staples, utilities, healthcare, and financials. This will help to ensure that your income is not overly dependent on any one sector and that you have exposure to different industries.You should also consider investing in both domestic and international stocks, as this can provide additional diversification benefits. International stocks can provide exposure to different economic conditions and currency fluctuations, which can help to minimize risk. It's also important to diversify across stocks with different dividend yields and growth potentials. This will help to balance the potential income and capital appreciation of your portfolio.


The easiest and most "auto-pilot" way to do diversify is to invest in dividend ETF's like $DGRO, $SCHD, $NOBL, or $JEPI. Remember, ETFs give you 100s of stocks under one umbrella. The ETFs mentioned all remove companies that reduce or eliminate their dividend. No work needed on your end.


In summary, diversifying your dividend portfolio is essential for minimizing risk and ensuring a consistent income stream. It's important to invest in a mix of stocks from different sectors and industries, both domestic and international, and with different dividend yields and growth potentials.


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Conclusion

In conclusion, living off of dividends during retirement can provide a consistent and predictable income stream, but it requires careful planning and regular monitoring. It's important to understand the risks and benefits involved, to diversify your portfolio, and to seek professional advice to ensure that you have enough income to meet your needs during retirement. Anyone can learn how to live comfortably off dividends during retirement! Start building you dividend income portfolio today and let it grow for years to come.


Happy Investing!

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