Using Dividends for Income: Focus on Stocks

By Gary Silverman, CFP®

Last week we began to look at how people might go about living off the income from their portfolios without touching their principal. This is a common request of people who come into my office. They see it as a safe way to invest.

In our last installment we examined using bonds and other fixed-income investments for this purpose. Two problems arose. The first was that bonds just don’t pay all that much income making it difficult for many people to support their retirement spending needs from the interest. The other problem was that bond portfolios tend not to grow…after all, their job is to give you income. So this week we’ll look at stocks because we expect them to grow.

To live off the income of your stock portfolio you’ll need your stocks to produce income. Not all stocks do this. Younger or rapidly growing companies use excess profits to reinvest in the company to help them grow. More mature companies who have more profits than growth possibilities return those excess profits to their owners. That’s you if you own the stock; these are called dividends.

There are many differences between dividends that stocks give out and interest that bonds produce, but I’ll only go through a few here. First, if you hold the stock for several months or longer (check with your tax preparer for the exact rules) the dividends are taxed at a lower rate than the rest of your income. In that way 2% of dividends ends up giving you more money to spend than 2% of interest from a taxable account (if the investments are inside an IRA they are taxed the same at your tax bracket when you withdraw the funds). The other good thing is that unlike a bond whose interest is (usually) fixed, a company can increase dividends across time as they themselves grow and produce more profits.

This dividend growth is a nice way to have your income rise across time as one of the problems with fixed income investments is their tendency to not grow as inflation balloons your expenses. However….

Just as dividends can grow, then can shrink or even stop. It is up to the company board to determine what is best for the company. If they are having a hard time of it, your dividend can disappear. And don’t think you can just go and sell that stock to buy another that still pays a dividend. If they are having trouble paying dividends you can be sure the price of the stock is down as well.

Another thing to realize is that stock dividends tend to be lower than interest paid from intermediate-term fixed-income securities. This means with interest rates so low, they are close to being the same, but those stocks that pay dividends tend to average about 2% even when interest rates are higher.

So far we’ve looked at issues in trying to produce what you need in retirement purely from interest and dividends. Next week we’ll wrap up this topic and answer the question: Are dividend paying stocks safer than those that don’t pay out?

Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing