Over the last several months I have had a number of people ask me about ways to make a “passive income” in the market. What they usually mean is, “how can I create a stream of income that I don’t have to work for?” This is indeed a great question and there are a great many opinions on this topic online (Google “passive income strategies” and you will see what I mean). Over the next few months, I am going to attempt to address a few of the most common strategies that I get questions about and give you my thoughts as to their effectiveness. The strategy that I am going to talk about today is commonly referred to as “dividend investing”. Dividends are defined are cash distributions from company earnings given to those who hold shares of a specific company. The amount and frequency of those dividends are determined by the company’s board of directors.
Large, “Blue Chip” companies are somewhat famous for paying dividends. These companies are also known for being relatively stable when compared to the rest of the market (think of the massive companies that have been around forever). When I say that large, dividend-paying companies are stable, what I mean is that they do not usually see much fluctuation in their stock price – up or down. This means that you are unlikely to see much growth in a dividend-paying company’s stock price. Therefore, if your goal is to grow your assets while also earning a passive income stream from your stocks, this is going to be an up-hill battle. Additionally, in order to create a significant income stream, you will also need to have significant assets to invest in that stock. Consider the following example:
- Company XYZ has a share price of $100
- Their annual dividend yield is 3.5% which means that each share pays $3.50/year
- In order to make an extra $500/month (or $6,000/year) in passive income you would need to own roughly 1,714 shares which would cost you about $171,428
If you are young and/or have a long time until retirement, this is not particularly appealing. While you would be creating a (somewhat) steady income stream, you would also be giving up significant growth potential. Basically, the growth/income tradeoff simply wouldn’t be worth it in this situation. It is also worth noting that in most circumstances the company has the ability to decrease or even skip dividends payments. Which means that dividends are by no means a “guaranteed” source of income.
The dividend investing strategy leans heavily on choosing a handful of individual stocks that pay out above average dividends with consistency. In addition to my point earlier about the “non-guaranteed” nature of dividends, this leads to another issue with diversification. In order to do the dividend investing strategy justice, you would need to completely eschew diversification in favor of holding highly concentrated positions in a handful of companies. While the inherent risk of this strategy may be acceptable for someone in the early years in investing, it would not be optimal for someone near or in retirement (for whom passive income would be most attractive). Even if you are young with a long-time horizon, diversification is your friend! Diversification reduces the impact of volatility in the market, reduces your allocation to a single asset class, and best positions you to take advantage of compounding returns.
As the saying goes, the only things certain in life are death and taxes and dividends are no different. If you truly intend to use dividend investing in order to create a passive income stream, then you should plan on paying taxes. Qualified dividends (i.e., dividends paid by a U.S. company) are taxed at the long-term capital gains rate[i]. This tax rate is lower than the normal ordinary income tax rate and only applies to those making at least $40,400 if single or $80,800 if married and filing jointly[ii]. If you are investing inside of a IRA or Roth IRA, you would not pay taxes until you withdraw from the account. However, if you are purposing to use dividends as passive income, you would be wise not to use a retirement account as withdrawals would result in additional fees (if you are younger than 59 and a half).
In closing, I believe that, while not impossible, it would be very difficult to create a passive income stream using this strategy without making major concessions in growth potential and diversification. The ability to make a significant income using this strategy is further hampered by taxes and the need for large sums of capital to invest. It is my opinion that this would not be an efficient way to create passive income for yourself.
Thanks for reading this week’s blog and I am sorry that you got stuck with back-to-back posts from me! Josh was out in San Diego last week for a conference and so I took his normal spot. But never fear, Josh will be back next week! Also, remember that, in addition to the written format, “A Wing and a Plan” is now being recorded as a podcast! If you would prefer to listen to our blog posts every week, subscribe to our new podcast which can be found on Spotify, Amazon Music, Google Podcasts, and iHeartRadio.
Last but definitely not least, our song of the week. Enjoy!
The opinions voiced in this blog are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. The examples presented are hypothetical examples and are not representative of any specific investment. Your results may vary.
[i] https://www.investopedia.com/ask/answers/090415/dividend-income-taxable.asp
[ii] https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates#:~:text=What%20is%20long%2Dterm%20capital,term%20capital%20gains%20tax%20rates.