How To Live Off Your Dividends

By Aaron Levitt | July 31, 2012 AAA

For most investors, a safe and sound retirement is priority number one. The bulk of many people's assets lie within accounts dedicated to that purpose; however, as daunting of a task as saving for a comfortable retirement is, living off of your investments once you finally do retire is equally as challenging.

Most withdrawal methods call for a combination of spending interest income from bonds and selling fund/stock shares to cover the rest. Personal finance's famous four-percent rule thrives on this fact. The four-percent rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that will allow funds to be withdrawn for a number of years. But what if there was another way to get that four or more percent from your portfolio each year, without selling shares and reducing principal?

One way to enhance your retirement income is to invest in dividend paying stocks and mutual funds. Overtime, the cash flow generated by those dividend payments can supplement your Social Security and pension income or perhaps provide all the money you need to maintain your pre-retirement lifestyle. It is possible to live strictly from your dividends, if you do a little planning.

SEE: Build A Dividend Portfolio That Grows With You

It's All About Dividend Growth
One of the best reasons why stocks should be part of every investor's portfolio is, unlike the interest from bonds, stock dividends tend to grow over time. More importantly, that dividend growth has historically outpaced inflation. For those investors with a long timeline, this fact can be exploited in order to create a portfolio that can be used strictly for dividend-income living.

The smart strategy lies within using those dividends to buy more shares of stock in a firm, so that they will receive even more dividends and buy even more shares.

For example, assume you bought 1,000 shares of a stock that traded for $100, for a total investment of $100,000. The stock has a 3% dividend yield, so over the past year you received $3 per share, or a total of $3,000 in dividends. Assuming the stock price doesn't move much, but the company increases its dividend by 6% a year, after 10 years the hypothetical portfolio will have $7,108 in dividends. After 20 years of dividend reinvestment, you will receive more than $24,289 a year in dividends.

SEE: How To Create A Modern Fixed-Income Portfolio

But What If You Are Already Retired?
Compounding of dividend income is certainly advantageous if you have a long-term timeline, but what about if you are about to enter retirement? For these investors, dividend growth plus a little higher yield could do the trick.

First, retired investors looking to live off their dividends may want to ratchet up their yield. High yielding stocks and securities, such as master limited partnerships, REITs and preferred stocks, generally do not generate much in the way of distributions growth; however, adding these to a portfolio would increase your current portfolio yield. That'll go a long way to helping pay the current bills.

Nonetheless, retired investors shouldn't shy away from classic dividend growth stocks like Procter & Gamble. These firms - especially those with higher average dividend growth rates - will increase dividend income at or above the rates of inflation and help power income into the future. By adding these types of firms to a portfolio, investors sacrifice some current yield for a larger pay-out down the line.

While an investor with a small portfolio may have trouble living off of their dividends completely, the rising and steady payments will go a long way into helping reduce principal withdrawals.

SEE: Strategies For Withdrawing Retirement Income

The Bottom Line
While most portfolio withdrawal methods involve combining asset sales with interest income from bonds, there is another way to hit that critical four-percent rule. By investing in quality dividend stocks with rising payouts, both young and old investors can benefit from the stocks' compounding, and historically inflation beating, distribution growth. All it takes is a little planning and investors can live off their dividend payment streams.

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