In the vast landscape of passive income, the spotlight often shines on its wonders. However, let’s shift our focus to a lesser-explored realm – the world of dividends, and unveil the simplicity of how they work.
In the midst of countless articles extolling the virtues of passive income, a closer examination reveals that not all sources are as hands-free as they seem. While they may promise a steady stream of income while you go about your daily activities, many of these avenues demand some level of effort on your part to keep the cash flowing.
Consider a blog – a promising source of income once established and running smoothly. Yet, the journey to that point requires considerable work, and ongoing management is essential. It’s more like a semi-passive endeavor than a completely hands-off venture. This leads us to the allure of dividend income, a pathway to genuine and hassle-free passive earnings.
Why Dividends Make Perfect Passive Income
Let’s start with a shared definition of passive income – income generated without any action from the recipient. Some investments fit this definition, like interest-paying investments such as certificates of deposit and U.S. Treasury bonds. However, these often yield less than 1%.
Real estate rentals are another form of passive income, but, like blogs, they’re semi-passive. You still need to manage the property to receive monthly income. On the other hand, dividend income stands out, especially in times of incredibly low-interest rates. Without much intervention, you can build a stock portfolio offering consistent returns of 3 to 4% annually.
It’s the best example of truly passive investment available today. While it takes significant capital to achieve desired income, once done, you can start earning a generous income – up to $1,000 per month in dividends. And when it works, you don’t have to lift a finger.
Dividend Stocks vs. Growth Stocks: What Sets Them Apart?
Now, an important distinction must be made regarding appreciation. Dividend stocks typically don’t appreciate as much as growth stocks. Growth stocks, as the name suggests, focus on expansion and pay little to no dividends. Take Amazon (AMZN) as an example – no dividends, but its stock price has surged from $170 per share a decade ago to well over $3,000.
So, if you’re seeking passive income, dividend stocks are the better choice between the two. Even if you hold several of these stocks, remember you won’t profit until the day of sale. Here, you benefit from an estimated value, and until then, they are gains only on paper.
Primary Benefit of High Dividend Stocks: Capital Appreciation
In this guide, we’ll focus on dividend income, but dividend stocks also have the potential for capital appreciation. After all, they are stocks and tend to appreciate over the long term.
Take Pepsi (PEP) as an example. Currently paying dividends of just under 3% annually, its stock price is around $143. Yet, you could have bought the stock for less than $65 ten years ago. This means the stock value more than doubled in 10 years – generating a fully passive 3% annual income.
This dual advantage of stable income and capital appreciation makes dividend stocks not only a hedge against inflation but also a vehicle for long-term growth. It makes dividend stocks one of the best investments and a highly recommended foundation for your portfolio. You can have other investments, but dividend stocks should constitute a significant portion.
Additional Perk of High Dividend Stocks: Tax-Friendly Treatment
Dividend-paying stocks not only offer much higher yields than interest-paying bonds but also come with certain tax benefits. Ordinary dividends are taxed as regular income for federal tax purposes. However, qualified dividends benefit from the lower tax rate on long-term capital gains.
To qualify as a qualified dividend, stocks must be issued by a U.S. or foreign company with shares traded on a U.S. stock exchange. You must also own the stocks for at least 60 days for the dividends paid on them to be considered eligible. While reduced (or nonexistent) tax rates don’t matter if you keep dividends in a tax-deferred qualified retirement plan, they are a significant benefit if kept in a taxable investment account.
Where to Find Dividend Stocks?
Dividend-paying stocks, especially those consistently delivering higher returns over many years, are typically issued by large companies with well-established financial histories. They are often household names, known for popular products or services, or industry leaders. Because of these qualities, in addition to their dividends, they are popular among investors.
There are three basic ways to invest in dividend stocks:
- Individual Stocks: The current average yield of all S&P 500 index stocks is 1.80%. You can focus on stocks with even higher dividend yields. While stock valuation software can help find these companies, an easier way is to check the list of high dividend payers known as Dividend Aristocrats. Currently, there are 65 companies on the list.
However, being a Dividend Aristocrat doesn’t guarantee a good investment. Companies come and go on the list, with new ones added and others removed most years.
- ETFs (Exchange-Traded Funds): If you don’t want to manage individual stocks, you can invest in ETFs specializing in dividend-paying stocks. These funds not only offer much higher current returns than interest-generating investments but also present double-digit total returns over the past decade. While they may not make you as wealthy as high-growth stocks, they offer stable and reliable returns. If you’re a long-term investor, this type of investment should dominate your portfolio.
- Real Estate Investment Trusts (REITs): A REIT is like a mutual fund investing in real estate instead of stocks, but not just any property. REITs primarily invest in commercial real estate, including office buildings, retail spaces, warehouses, large apartment complexes, and similar properties. They are also legally required to distribute at least 90% of their profits to shareholders in the form of dividends. This consists of a combination of net rental income and capital appreciation distributions from properties sold. Simplifying it, REITs typically pay dividends monthly.
However, the long-term performance of REITs hasn’t been good in recent years. Both Brookfield Property REIT and Kimco Realty Corp have experienced significant price declines over the past 10 years, despite consistently paying high dividends. Brandywine Realty Trust performed better in capital appreciation and remained stable over the last decade.
Building a Portfolio for a Stable Monthly Income
If you want to receive monthly dividends, you need to structure your portfolio with a mix of companies paying dividends in different months within the same quarter. Companies typically pay dividends quarterly. REITs are an exception; they pay dividends monthly. To achieve monthly income, you’ll need to spread dividend payment dates for monthly income.
For example, using the sample table’s stocks, Cardinal Health pays dividends in January, April, July, and October. General Dynamics pays dividends in February, May, August, and November. AFLAC pays dividends in March, June, September, and December.
There’s no need to distribute dividend payments across the portfolio if you only need monthly income. However, since each company pays dividends on different dates, it’s challenging to find a combination of stocks generating exactly $1,000 in sales per month. It’s possible, but difficult.
An alternative is to disregard payment dates, transfer quarterly dividends to a checking account, and average monthly income from the total quarterly amount.
Dividend stocks may not be as glamorous as growth stocks, but they are the type of investment that creates lasting wealth and the kind of income you can earn while doing absolutely nothing. Who wouldn’t want that return? Dividend stocks are particularly appealing for retirement portfolios. Not only do they provide a reliable way to accumulate wealth over decades, but they also ensure a steady stream of income until retirement age. You can use 3% to 4% of dividend income to live as stock prices increase in value over time.
Of course, this requires a much larger portfolio. But if you want to get rich or retire with a seven-figure portfolio, you can also enjoy a generous income with it.