Passive income for the win.
As more and more people educate themselves on ways to live job-free, the idea of passive income is becoming increasingly popular. For folks interested in investing, this line of thinking inevitably leads to dividends.
Dividend payments can be an excellent way to live off your investments -- without having to sell off shares and erode your principal. But how much do you really need to invest to make dividends a worthwhile income source? The answer is highly variable depending on the person. Let's dive a little deeper.
How dividends work
When a company generates a profit, they have a few options of what to do with it. They can invest that profit back into the company, or they can pay out that profit. (Or, as is often the case, they can reinvest some and pay out some.)
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For privately held companies, that profit would likely go to the owners of the company. In co-ops, the profit may be paid out to the members (who are technically the "owners").
In a publicly traded company, that profit is often paid out to the shareholders. In this case, these payouts are called dividends.
If you've purchased stock in a company, you're now a shareholder. So if that company pays dividends, you're entitled to a portion of the profit based on how many shares you own.
Dividends can be paid out as cash (either as a digital deposit or as a check) or as additional shares of company stock. How often dividends are paid out varies by company, though quarterly payouts are most common.
Dividend yield
The dividend yield -- the percentage of the share price paid out -- can vary from company to company, and even from year to year for the same company. In general, larger, more mature companies pay out larger dividends than smaller, younger companies.
You can calculate a dividend's yield with this simple formula:
Dividend Yield = Annual Dividends Per Share / Price Per Share
For example, if a particular stock has a price per share of $50 and pays $5 in dividends a year, its dividend yield would be: $5 / $50 = 10%.
Calculating your investment needs
To figure out how much dividend income you'll need to live off of, you first need to figure out how much income you're going to need each year. This will vary depending on your lifestyle wants and needs.
Remember: Most dividends are paid out quarterly, so you may not get regular monthly income unless you have a variety of dividend-paying stocks with staggered payout dates.
A good place to start is looking at your current income and expenses. If your current income is enough to sustain the lifestyle you want to live in retirement, then use that as your starting point. (Make sure you consider things that could impact your future expenses, like inflation and increasing medical costs as you age.)
Once you know how much income you need each year, you can simply divide that amount by the average dividend yield to get an idea of how much you need to invest.
For example, say I need to earn $50,000 a year to live comfortably and my average dividend yield is 5%. So, I would need to own $50,000 / 0.05 = $1 million worth of shares to meet my income needs. (Note that this is a bit oversimplified -- there are also taxes to consider.)
Pro tip: Don't forget that dividends can vary from year to year, or even quarter to quarter. You can't just invest your money and then ignore it -- you'll want to keep an eye on your portfolio to ensure you're always getting the best return for your money.
Building up to your goal
In my quick example above, I got a result of $1 million in investments. Now, that is a lot. That's why it's important to start saving and investing as soon as you can, so you can give yourself the best chance of reaching your goals.
And yes, some may even argue that $1 million alone would be enough to sustain a decent retirement (though inflation and rising cost of living would beg to differ). But the benefit of living off of dividends is that you don't have to touch your principal investment to pay the bills.
This means you always have that nest egg of investments to rely upon in case you need it. Moreover, no one knows exactly how long they're going to live -- and, thus, how long they're going to need their savings to last. If you can live off of dividend income alone, you can meet your needs more or less indefinitely.
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